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    kellogg annual reports 2003 kellogg annual reports 2003 Document Transcript

    • EARNING OUR STRIPES. ANNUAL REPORT 2003
    • NET SALES (millions) OPERATING PROFIT (millions) $8,812 $8,304 $1,508 $1,544 $7,548 $6,110 $6,157 $6,087 $1,168 $990 $895 $829 98 99 00 01 02 03 98 99 00 01 02 03 We again posted strong internal sales We were able to increase our operating profit in 2003 growth in 2003, driven by brand building while making substantial investments for the future. and innovation across our portfolio. EARNINGS PER SHARE (diluted) CASH FLOW (millions) $1,000 $1.92 $961 $1.75 Voluntary $856 Benefit Plan Contributions $1.45 $650 $1.23 $1.16 $529 $0.83 $346 $746 $924 98 99 00 01 02 03 98 99 00 01 02 03 We again delivered better-than-expected Cash flow again exceeded expectations, as we increased earnings growth in 2003. earnings, remained disciplined on capital expenditure, and improved our working capital efficiency. TOTAL SHARE OWNER RETURN In 2003, we earned our Kellogg S&P Packaged Foods Index stripes by delivering 26% 19% 17% solid results, while 15% 8% 5% 3% 2% strengthening our -7% organization and -11% -21% -29% creating a future of 98 99 00 01 02 03 dependable growth. For the third straight year, our total share owner return well outpaced our peer group.
    • 2003 ANNUAL REPORT With 2003 net sales of almost $9 billion, Kellogg Company is the world’s leading producer of cereal and a leading producer of convenience foods, including cookies, crackers, toaster pastries, cereal bars, frozen waffles, and meat alternatives. The Company’s brands include Kellogg’s ®, Keebler ®, Pop-Tarts ®, Eggo ®, Cheez-It ®, Nutri-Grain ®, Rice Krispies ®, Murray ®, Austin®, Morningstar Farms ®, Famous Amos ®, Carr‘s, Plantation, Ready Crust®, and Kashi ®. Kellogg products are manufactured in 17 countries and marketed in over 180 countries around the world. FINANCIAL HIGHLIGHTS 2003 Change 2002 Change 2001 Change (dollars in millions, except per share data) Net sales $8,811.5 6% $8,304.1 10% $7,548.4 24% Gross profit as a % of net sales 44.4% -.6 pts 45.0% .8 pts 44.2% .1 pts Operating profit 1,544.1 2% 1,508.1 29% 1,167.9 18% Net earnings 787.1 9% 720.9 52% 473.6 -19% Net earnings per share Basic 1.93 9% 1.77 51% 1.17 -19% Diluted 1.92 10% 1.75 51% 1.16 -20% Cash flow (net cash provided by operating 923.8 24% 746.4 -13% 855.5 32% activities, reduced by capital expenditure) (a) Dividends per share $ 1.01 — $ 1.01 — $ 1.01 2% (a) The Company uses this non-GAAP financial measure to focus management and investors on the amount of cash available for debt repayment, dividend distributions, acquisition opportunities, and share repurchase. Refer to Management’s Discussion and Analysis on page 25 for reconciliation to the comparable GAAP measure. TABLE OF CONTENTS 2 Letter to Share Owners 31 Selected Financial Data 8 Growing Our Sales 32 Consolidated Financial Statements 17 Improving Our Profitability 35 Notes to Consolidated Financial Statements 18 Turning Our Profit Into Cash 52 Management’s Responsibility for Financial Statements 19 Helping the Community 52 Report of Independent Auditors 20 Providing Nutrition to Our Consumers 54 Board of Directors 21 Living the K Values 57 Share Owner Information 22 Management’s Discussion and Analysis
    • TO OUR SHARE OWNERS It is a pleasure to write to you on behalf of over 25,000 Kellogg employees and our Board of Directors, all of whom are committed to making this great Company even more dependable than ever before. We know that a track record and reputation for dependability cannot be built overnight – we must earn our stripes each and every day, in all aspects of our business. That’s why I am so proud of our performance in 2003. We not only deliv- ered solid results again in a challenging environment, but we also took important steps toward creating our future and strengthening our organization.
    • Delivering Results Creating Our Future By any financial measure, we certainly earned our As good as our 2003 performance was, our goal is not stripes in 2003. to deliver one year of exceptional results. We believe the best way to create value for you is to deliver consistent, • Our share price increased 11% in 2003, even as in- dependable growth, year after year. This means contin- vestors shifted toward more economically cyclical sec- ually enhancing our capabilities and reinvesting in the tors of the stock market. Importantly, this share-price business. In 2003, we boosted our brand-building appreciation outpaced our peer group of large-cap investment by approximately 15%. We increased and packaged food stocks for the third consecutive year. improved our advertising, and we had a full calendar of Including dividends, our total return to share owners promotional campaigns designed to excite consumers. was more than 14% in 2003, well ahead of our peers. Additionally, our innovation efforts yielded promising The performance brought our three-year compound new products in all of our businesses. These activities annual return to almost 17%. This exceeds our peer strengthen our brands and create momentum for group’s 3% average over that same three-year period, the future. and it is well above the broader S&P 500 stock index, which declined an average of 4.5%. We also invested in cost-savings projects. Over the course of 2003, we rationalized capacity in several • Our net sales increased by 6% in 2003. Internal net countries and took steps to reduce overhead. These ef- sales growth, which excludes favorable foreign forts will generate substantial savings in future years, currency translation and the effect of two small but they required up-front investment in 2003, in the divestitures, was a solid 4%. This came on top of a form of asset write-offs and other costs. similar gain in 2002. This growth on growth, along with the fact that most of our portfolio shared in this As good as our 2003 performance was, our growth, is a sign of sustainability. For the 2001-2003 period, our compound annual growth rate for net goal is not to deliver one year of exceptional sales was 13%; on an internal basis, excluding results. We believe the best way to create currency and acquisitons, our growth averaged 3%. value for you is to deliver consistent, • Our earnings per share grew by 10% in 2003. This dependable growth, year after year. exceeded our high single-digit growth target, and even more impressive was the quality of these earnings. Through productivity initiatives and a favorable shift in We also shaped the future by improving our financial our sales mix, we were able to offset the impact of flexibility. In 2003, we reduced our debt by more than sharply higher costs, especially for raw materials, fuel, $550 million. We have now paid down $1.6 billion of and pension and health-care benefits. We also signifi- debt since the acquisition of Keebler Foods in March cantly increased our investment in brand building and 2001. This is an outstanding accomplishment, and one innovation, and incurred substantial asset write-offs, im- that reflects our focus on the generation of cash flow. pairments, and up-front costs related to improving We further created financial flexibility in 2003 by again future productivity. This growth amidst reinvestment is making voluntary contributions to our pension and another sign of sustainability. For the 2001-2003 period, retiree health-care benefit funds. These contributions our compound annual growth rate for EPS was 10%. raised our funding levels for these financial obligations, • Our cash flow* was $924 million in 2003, once and they mitigate future benefits expense. again ahead of our expectations. Driving this cash flow was not only strong earnings growth, but contin- ued improvement in our management of working cap- ital and good discipline on capital expenditure. We have become a far more efficient generator of cash. * Cash flow is defined as cash from operating activities less capital expen- For the 2001-2003 period, our compound annual ditures. Refer to Management’s Discussion and Analysis on page 25 for reconciliation to the comparable GAAP measure. growth rate for cash flow was 12%. Kellogg Company 3
    • Strengthening Our Organization • Putting the right people in the right jobs has been critical to our renewed success. In 2003, we made Our founder, Mr. W. K. Kellogg, was fond of saying “I’ll several transitions and promotions of key executives, invest my money in people.” In 2003 we launched or each intended to better leverage their strengths and continued various initiatives designed to invest more in to further develop their skills. our people: David Mackay, whose leadership drove the impressive • We launched an initiative called Talent turnaround of our U.S. businesses, was promoted to Management Worldwide aimed at building a more president and chief operating officer of the Company. comprehensive and systematic approach to David and I have complementary strengths and create identifying, training, and developing future leaders. a strong partnership in leading this Company. Our chief financial officer, John Bryant, has added to his • We conducted a Company-wide culture survey, responsibilities the leadership of our U.S. Natural & which helped us better understand the strengths and Frozen Foods division, giving John the experience of opportunities of our culture and environment. Every having business unit accountability. business unit, department, or corporate function is using the results to improve our employee satisfaction After very successfully leading the implementation of and become a better place to work. We plan to our Volume to Value strategy in international markets repeat the survey every two years. and driving strong sales growth in those markets, Alan Harris was named executive vice president, chief • We continued to hold workshops to spread marketing and customer officer. This is a new role de- the K ValuesTM, a set of guiding principles that signed to better implement the sharing of innovation were updated in 2002. In fact, most of our and marketing programs across the Company. management around the world has now participated in these sessions. Jeff Montie became an executive vice president of the Company, and Canada was added to his • We have formally made diversity and employee responsibilities. His leadership of our U.S. Morning safety priorities for 2004 and beyond. Our K ValuesTM Foods division has resulted in substantial growth call for us to show respect for and value all individuals and share gains, especially in cereal. Brad Davidson for their diverse backgrounds, experience, styles, ap- was promoted to senior vice president of the proaches, and ideas. The sustainability of our business Company, and put in charge of our U.S. Snacks divi- is dependent upon our ability to generate new ideas sion after successfully leading our U.S. Morning and to respond to consumers with changing Foods sales force. demographic profiles. Equally important is employee safety. High safety levels in the workplace are Several other executives were promoted in correlated with positive employee morale, strong pro- recognition of their strong contributions to the ductivity, and reduced costs. Company. Gary Pilnick was promoted to senior vice president, general counsel and secretary, and Celeste Earning Our Stripes 4
    • Clark to senior vice president with worldwide respon- category across the globe, giving us the best sibility for Corporate Affairs. Key general managers opportunity to expand consumption. When managed from around the world were named corporate officers well, we can generate strong, profitable growth in for the first time: Elisabeth Fleuriot, managing direc- cereal. In 2003, our U.S. cereal sales increased by 7%, tor, Kellogg France, Benelux, Scandinavia, South and our international cereal sales were up 4% in Africa; Juan-Pablo Villalobos, managing director, local currencies. Kellogg de Mexico; and Paul Norman, managing director, United Kingdom/Republic of Ireland. Their We believe it is a competitive advantage to promotions reflect the value of their personal contri- concentrate our resources on categories in butions and the strategic importance of these markets. which we have scale, expertise, and leading The result is a stronger organization: The right people in brands, as opposed to participating in a the right jobs; a commitment to develop tomorrow’s leaders; steps to create a safer, more diverse workforce; large number of categories that can distract and a winning culture. This, more than anything else, us from what we do best. will make us an even better company in the future. Expand Snacks. Snacks, and particularly wholesome Our Game Plan for 2004 snacks, continue to grow faster than other food categories. We are well positioned to participate in this and Beyond growth. We have strong, extendable brands and an ex- pertise in grain- and fruit-based foods. In the U.S. and We are in the enviable position of not having to create a Mexico, we have direct store-door distribution, giving us new strategy. We already have a game plan, an an in-store advantage. And wholesome snacks are usu- approach to the business that can achieve dependable ally located right in the cereal aisle. growth. Shaped by many people throughout our Company, it has evolved over the past few years into a In 2003, we showed continued progress in expanding simple and distinctly Kellogg plan. Our challenge now is our snacks business. Core international markets such to continuously improve our execution. as Mexico, Australia, and the U.K. showed strong dou- ble-digit net sales growth in snacks, and their innova- The game plan centers on the following priorities: tion pipelines are strong. Our success has attracted a lot of competition, and yet we have held our own in • Sticking to our Focused Strategy tough environments. We are a very focused company. Between cereal and wholesome snacks, the vast majority of our sales take In the U.S., while wholesome snacks have performed place in a single aisle of most stores and channels. We extremely well, they represent less than 20% of U.S. believe it is a competitive advantage to concentrate our Snacks’ sales. Their double-digit sales growth in 2003 resources on categories in which we have scale, expert- was offset by a decline in cookies sales, amidst weak ise, and leading brands, as opposed to participating in a category demand and price promotion by competitors. large number of categories that can distract us from A key priority for 2004 will be stabilizing our cookies what we do best. Our strategy underscores our focus: business, while maintaining share in crackers and grow- Grow Cereal, Expand Snacks, Pursue Selective ing wholesome snacks. Growth Opportunities. Pursue Selective Growth Opportunities. Beyond ce- Grow Cereal. Ready-to-eat cereal accounts for more real and snacks, we also participate in other nearby cat- than half of our Company’s net sales: That’s a good egories using strong regional brands. For example, in thing. Cereal is a large and profitable category that re- the U.S. we have Pop-Tarts®, #1 in toaster pastries; acts to brand building and innovation. It offers Eggo®, the leading frozen waffle brand; and consumers convenience, fun, and great taste, and it Morningstar Farms®, the largest frozen meat- contributes to a healthy, well-balanced diet. It’s also alternatives brand. Brands like these offer good, what we do best. We have leading shares in this profitable growth. Kellogg Company 5
    • We are also identifying new opportunities through and accounts payable). The improvements we have acquisitions, alliances, and innovation. These investments made in this area are remarkable, and we will continue will be in consumer-driven categories in which we can to enhance our working-capital efficiency in 2004. We’ll use our core competencies. These are categories in also remain disciplined on capital expenditure, prioritiz- which we can leverage our brands, supply chain, and in- ing resources for the highest-return projects and using novation expertise with grains and fruit. They also can existing assets whenever possible. With greater cash build on our existing customer relationships and channel flow, we can improve our financial flexibility over time and aisle focus. In 2003, for example, we extended by paying down debt, making contributions to our ben- Eggo® into the related syrup category, and Nutri-Grain® efit plans, making small tack-on acquisitions, or return- into granola. These required very little capital ing cash to share owners through share repurchases and investment and they leverage existing brands. dividend increases. • Adhering to our Financial Model The entire organization is intensely We continue to manage our business based on two sim- focused on executing our plans, earning ple operating principles: Volume to Value and Manage our stripes each and every day. for Cash. These principles are designed to create sustainable financial performance, and they are under- stood by the entire organization. While Volume to Value enhances and sustains our earn- ings growth, Manage for Cash ensures discipline over Volume to Value means adding value for consumers our capital base. Together, these principles increase our through branded, differentiated products – and getting return on invested capital. paid for that added value. It means focusing on sales dollars and not tonnage volume. It requires improving Another element of our financial model is realistic finan- our gross profit margin so that we may invest more in cial targets. When earnings growth targets are unrealis- brand building and innovation, drive our most valuable tically aggressive, business managers are inevitably com- brands, and grow our net sales. In 2003, we achieved pelled to make short-term decisions that may hurt their all but one of the underlying Volume to Value metrics. business over the long term. Such decisions could The exception was gross profit margin expansion, and include cutting brand-building investment, over- that was because we incurred investment costs related shipping to customers, or relying on price promotion. to future productivity initiatives. We expect to achieve Our goal is sustainable growth, even if it means target- all of the Volume to Value targets – including improved ing a more modest earnings growth rate. Our long-term gross profit margin – in 2004. growth targets are low single-digit net sales growth, mid-single-digit operating profit growth, and high Manage for Cash is the principle that focuses our single-digit EPS growth, and we will stick to these Company on generating cash flow. Each of our targets in 2004. We believe having these realistic targets businesses is working to reduce the amount of cash tied empowers and motivates our employees, and gives us the up in working capital (accounts receivable, inventory, flexibility to invest for sustainable growth in the future. Earning Our Stripes 6
    • • Leveraging our Leading Brands In 2002, we planned for a year of acceleration in sales and earnings, and we actually exceeded our targets that We are first and foremost a branded food company. We year. By 2003, our business was expected to exhibit mo- are not interested in participating in private label or low- mentum, and it did: We surpassed our sales and margin segments, where the economics do not allow us earnings growth targets while reinvesting for the future. to add value through brand building and innovation. Kellogg brands have several advantages. They are The success of these past three years is evidence that known and trusted in markets all over the world. They we are up to the challenge of generating sustainable extend effectively into close-in categories, such as earnings and cash flow growth in the future. The en- wholesome snacks, and they transfer easily across coun- tire organization is intensely focused on executing tries and regions. our plans, earning our stripes each and every day. Our goal is to be a dependable, long-term investment We will continue to leverage and extend our brands for you. We are grateful for your confidence in our across our geographic and product portfolio. Here’s a special Company, and we trust you are as optimistic great example of what we can do: In recent years, about our future as we are. Special K® cereal led to Special K® Red Berries cereal, which in turn, led to Special K TM bars. Today, Special K is a $500 million worldwide brand sold in 40 countries. • Utilizing our Worldwide Infrastructure It would require billions of dollars and many decades to even attempt to replicate our worldwide infrastructure. Moreover, because of our focused strategy, we have fairly consistent portfolios across the globe. We see this as an advantage for Kellogg. It enables us to transfer our best ideas quickly around the world, and across business units. These ideas can be proven innovations and brand-building concepts, but they can also include productivity enhancements and management processes and practices. We Are Up to the Challenge In late 2000, we laid out our plan to return Kellogg to sustainable growth. We changed our strategy and our organizational structure. The year 2001 was to be a year Carlos M. Gutierrez of transition. We purchased Keebler Foods, the largest Chairman of the Board acquisition in our history. We essentially overhauled the Chief Executive Officer entire Company while still achieving our earnings goals. Kellogg Company 7
    • EARNING OUR STRIPES We’re not just and that requires earning our stripes, too. We are contin- talking about ually identifying ways to be more efficient, rationalizing earning our our capacity, shifting our mix to more profitable business- stripes – we’re es, and controlling overhead expenses. Ultimately, the doing it. Every value of our Company – and your stock – is driven by the day, across the cash flow we generate. So, we earn our stripes by turning globe, Kellogg our sales and profit into cash, by limiting our capital people are deliv- expenditure to high-return projects, using existing assets ering results and wherever possible, and reducing the amount of cash we creating the have tied up in inventory and accounts receivable. These future. In the pages that follow, you’ll read about these are only the financial elements of dependability and sus- efforts, especially as they relate to sustaining our growth. tainability – we also must earn our stripes with our Growing our sales requires earning our stripes in so many employees, our communities, and our consumers. Simply ways: Improving our advertising and promotion programs; put, our entire organization is focused on executing our launching more, differentiated new products; finding new plans and making this an even better company tomorrow revenue streams within our focused strategy; partnering than it is today. with our customers and executing better in the store. To fuel our growth, we’ll need to increase our profitability, A. D. David Mackay President and Chief Operating Officer GROWING OUR SALES Our brand-building investment, which includes advertis- Expand Gross Profit ing and consumer promotions, increased at a double- Margin digit rate in 2003, substantially outpacing our net sales growth. This underscores our commitment to sustaining Grow Net Sales the strength and growth of our valuable brands. Not Increase only did we spend more, but we also improved the Brand VOLUME Building effectiveness of these brand-building efforts, as a focus to on execution and the sharing of proven ideas from VALUE around the world led to better programs. We also stepped up our innovation activity. Net sales from prod- Improve Mix ucts launched within the last three years again Drive Innovation approached 15% of total sales in 2003, an outstanding contribution. These product and packaging innovations The first step to sustainable cash flow growth is growing created excitement for consumers, leveraged our exist- our sales. Volume to Value has our entire organization ing brands and manufacturing capacity, and shifted our focused on profitable net sales growth, rather than on mix toward more profitable sales. Meanwhile, as we simply increasing tonnage. This means adding value to used brand building and innovation to drive demand, our products, through brand building and innovation, we were able to rely less on discounting, which further instead of relying on price discounts. It also means con- helped our net sales growth. centrating our marketing and sales resources on our Most encouraging is the fact that virtually all of our most profitable brands, as well as launching new prod- businesses in 2003 were successful in using Volume to ucts that have more favorable profit margins than our Value to generate profitable sales growth. portfolio average. Solid execution of this principle led to our strong 6% net sales gain in 2003. Earning Our Stripes 8
    • U.S. Retail Cereal We also benefited from new products. Fruit Harvest TM, Tony’s Cinnamon KrunchersTM, and SmorzTM were new Our U.S. Retail Cereal business had another outstand- brands launched early in the year, followed by brand ing year in 2003. It posted net sales growth of 7%, extensions like Maple & Brown Sugar Frosted Mini- even though it compared with a similarly strong 6% Wheats®, and Special K® Vanilla Almond. Our Kashi® gain in 2002. This growth on top of growth led to a natural cereal brand continued its strong growth, aided fourth consecutive year in which we increased our by new products like Organic PromiseTM Autumn share of the U.S. cereal category. That we can contin- Wheat TM, and Seven in the MorningTM; the latter serves ue to grow in a category considered to be fully devel- up a nutritional seven grains, seven grams of protein, oped is a testament to the power of brand building in and seven grams of fiber per serving. this business. U.S. Retail All Cereal Other U.S. Retail Cereal: Latin Am. Internal Net Sales Growth 7% 6% Europe 2% 2001 2002 2003 U.S. Retail Snacks Year-Over-Year % Change U.S. Other % of KELLOGG NET SALES These are all examples of bringing excitement to the In 2003, we continued to both increase and improve our category, adding value for the consumer, and contribut- advertising and consumer promotions in this business. ing positively to our key Volume to Value metrics. Our Strong advertising campaigns lifted several brands, such sales force continued to execute well at the store level, as Froot Loops® and Rice Krispies®. Apple Jacks® grew as our in-store representatives were successful at reduc- when children voted to add blue “carrots“ to the cereal. ing out-of-stock products and increasing feature and Disney® toys in the box helped drive growth in Kellogg’s display activity. The combination of all these efforts led Frosted Flakes® and Smacks®. A weight-loss campaign to sales and share momentum in our U.S. cereal busi- again lifted sales for Special K® and Special K® Red ness and reaffirmation of Kellogg Company’s position Berries. We launched promotional cereals and inserts as a key partner to our retailer customers. tied to popular movies like the “Cat In the Hat”, and holiday-themed versions of brands like Rice Krispies. Kellogg Company 9
    • Kellogg U.S. Ready to Eat Cereal: All Other Category Share U.S. Retail Latin Am. Cereal 34 33 Europe 32 U.S. Other 31 U.S. Retail Snacks % of KELLOGG NET SALES 30 2000 2001 2002 2003 impulse-driven wholesome snacks business, including Source: Information Resources, Inc.; Food, Drug & Mass channels, excl. Wal-Mart. Rolling 52-week periods. our Nutri-Grain® and Rice Krispies Treats® brands. Sure enough, the transfer to DSD has resulted in greater dis- We expect to continue to grow our U.S. cereal busi- play activity for these products while improving the ness. While it would be unrealistic to expect the same economics and effectiveness of our new-product kind of exceptional growth that we realized in 2003, launches. In 2003, we launched Cereal and Milk bars, we do project continued sales growth driven by brand leveraging some of our best cereal brands, and they building and innovation. In fact, we believe our 2004 quickly gained distribution, display, and consumption lineup of new products, advertising campaigns, and growth. Special K TM bars have been a great success, promotions is every bit as strong as that of 2003. continuing to post strong growth in 2003 despite com- paring against their previous-year launch. Late in the Kellogg U.S. Retail Snacks Sales at Retail year, we launched a new Nutri-Grain® Granola line. Wholesome Snacks Cookies Crackers –% Cookies -7% Wholesome Snacks +18% Portfolio –% Crackers Year-Over-Year % Change Source: Information Resources, Inc.; Food, Drug & Mass channels, excl. Wal-Mart. Year-to-date period through December 28, 2003. U.S. Retail Snacks In 2003, our U.S. Retail Snacks sales remained even Our California-based Kashi team certainly has been with 2002. However, the discontinuation of a less prof- earning its stripes. Kashi sales have quadrupled since itable custom manufacturing account, coupled with an Kellogg acquired the company in 2000. Its performance aggressive effort to eliminate stock keeping units has been clearly aligned with the principles of Volume (SKUs), meant the loss of about 2% of this business’ to Value, featuring investment in brand building and sales. These actions were designed to improve prof- innovation, along with focused execution. The result itability and to allow us to focus our resources on our has been increased consumer awareness and strong most valuable brands. positions in multiple categories. This has been a great success story driven by the teamwork and passion of Impressively, our wholesome snack brands collectively the Kashi team. posted strong double-digit sales growth in 2003. A key premise of the 2001 Keebler Foods acquisition was that #1 in $227MM 52% Keebler’s direct store-door (quot;DSDquot;) distribution system Category Dollar Share would profitably lift sales growth for the freshness- and Source; Information Resources, Inc., Food, Drug, and Mass Channels, excluding Wal-Mart; 52 Weeks ending 12/28/03. Natural Cereal Channel. Earning Our Stripes 10
    • Our crackers’ sales grew modestly in 2003. This was led Other U.S. Businesses by Cheez-It® crackers, the powerful brand we prioritized Our other U.S. businesses collectively posted internal for brand building and innovation. A new advertising sales growth of 3% in 2003. This group includes lead- campaign and several new product offerings, such as ing brands and alternative channels that present excel- Parmesan Garlic, Chili Cheese, and Sour Cream & lent opportunities for profitable growth. Onion, drove double-digit sales growth for Cheez-It in 2003. Not surprisingly, the cracker brands that received All U.S. Retail brand-building and innovation investment showed good Other Cereal Latin Am. growth. In addition to Cheez-It, we also experienced solid sales gains in our Club® and Toasteds® brands. Europe The only soft spot in our U.S. Retail Snacks portfolio in 2003 was our lower-margin cookies segment. Overall cookies consumption declined, amidst a relative lack of U.S. Retail Snacks brand building and innovation in a category that thrives U.S. Other on this kind of investment. Our decision not to follow % of KELLOGG NET SALES competitors’ price promotion activity resulted in less feature and display activity, further dampening our sales Pop-Tarts®, the leader in toaster pastries and our of this impulse-driven product. There is no question we largest brand in the U.S., achieved this year’s good need to battle more aggressively in the store and boost results despite new competitive entries and compar- the quantity and quality of our cookies’ promotion and isons with notably strong growth the year before. New innovation. As in crackers, the select cookie brands in products like Pop-Tarts® Yogurt BlastsTM offered deli- which we increased brand building and innovation did cious new alternatives to the traditional Pop-Tarts line show good growth in 2003: The E.L. Fudge®, Sandies®, and the “Chill ’Em” advertising campaign, which and Murray ® Sugar Free brands each posted retail sales urged consumers to try chilling Pop-Tarts, was a great and share gains. The priority now is to spread that success. Pop-Tarts sponsored the American Idol® tour, investment to more of our key cookie brands in 2004. and launched limited-edition Pop-Tarts for our “Cat in Our forecasts for 2004 incorporate only minimal sales the Hat” movie tie-in. growth from our U.S. Retail Snacks business. This is a Other U.S. Businesses: result of the impact of the discontinued custom manu- Leaders in Each Category facturing account and eliminated SKUs, along with competitors’ price promotion in cookies. However, we anticipate being able to defend our cookies position, #1 in $459MM 80% while maintaining our cracker sales and continuing to Category Dollar Share post solid growth in wholesome snacks. We have restructured our sales force and simplified the portfolio, #1 in $520MM 64% Category Dollar Share and we have planned a solid calendar of innovation, advertising, and in-store merchandising. Now it’s time #1 in $369MM 43% Category Dollar Share for execution, and we believe we have the brands, the distribution system, and the people to grow this busi- Source; Information Resources, Inc., Food, Drug, and Mass Channels, excluding Wal-Mart; 52 Weeks ending 12/28/03. Categories are ness for many years to come. Toaster Pastries, Frozen Waffles, Frozen Veggie Foods. Kellogg Company 11
    • We continued to expand the all-natural Kashi ® brand from the Keebler acquisition, we go to market in the beyond cereal. New flavors of Kashi® GoLean® snack bars foodservice, vending, and convenience-store channels were added to the line in 2003, and we had good first-year as a much stronger company. Good innovation and success with Kashi TLCsTM and KashiTM frozen waffles. sales efforts in 2003 allowed us to continue to gain share in the foodservice channel in all three of our Our Kellogg’s Krave® snack bars were launched nation- largest categories: cereal, cookies, and crackers. ally after two years in test market. This product offers con- sumers a delicious and more wholesome alternative to tradi- We project another year of profitable growth for tional confectionery bars, and gives us another opportunity in these other U.S. businesses in 2004. Each of these the supermarket aisle we love best—the one with cereal, toast- brand equities, as well as our food-away-from-home er pastries, and wholesome snacks. business, should benefit from new products and con- tinued emphasis on execution, both in brand building Other U.S. Businesses: and innovation. Internal Net Sales Growth 5% 3% 2002 2003 Year-Over-Year % Change We continue to generate growth in frozen foods. The leading frozen waffle brand, Eggo, grew on the strength of new products. These included line exten- sions like Eggo ® Froot LoopsTM frozen waffles, a limited edition Scooby DooTM frozen waffle, and new products such as Eggo® French Toaster Sticks. Late in the year, we extended the Eggo brand into a related category, syrup; this is an example of how we can add incremen- tal sales to existing brands without significant invest- Created only two years ago, our Ethnic Marketing ment or risk. Our meat alternatives business, principally Team has made great strides in reaching out to a under the category-leading Morningstar Farms brand, growing part of the U.S. population. In 2003, the also grew through innovation. New Morningstar Farms® team executed several successful promotions for this Parmesan Ranch Chik Patties®, for example, took market. One was our MUSI Kellogg’s Tour, an advantage of increasing consumption of non-burger Hispanic music tour. Similarly, the first Spanish-lan- products in the frozen meat alternatives segment. guage advertisement for our Special K® brand was a huge success, driving a significant increase in sales in The food-away-from-home channel was challenging for the Hispanic market. These efforts are good exam- most food companies during the past two years, but ples of earning our stripes in the marketplace. our business continued to grow. Benefiting from the increased scale and broadened portfolio that resulted Earning Our Stripes 12
    • Europe Europe: Accelerated Net Sales Growth Our net sales in Europe jumped 18% in 2003, or about 3% 2% 3% when adjusted for foreign currency translation. Our -2% longstanding presence in Europe, high category shares, and enduring brands generate solid returns on invest- 2001 2002 2003 ment. The implementation of Volume to Value in 2002 % Growth, Local Currency and 2003 led to accelerated sales growth for this region. All Other U.S. Retail Latin Am. Cereal Europe: Clear Cereal Leader Europe in All Key Countries RTE Cereal, Value Share Kellogg #2 U.S. Retail Kellogg Year Entered Ranking Share Share Snacks U.S. Other UK 1922 43% #1 17% FRANCE 1968 44% #1 27% % of KELLOGG NET SALES GERMANY 1950 26% #1 21% IRELAND 1929 56% #1 18% The U.K. is a notable success story. After implementing SPAIN 1977 52% #1 18% Volume to Value and building up an impressive pipeline ITALY 1967 56% #1 23% of innovations and consumer promotions, our cereal NORDIC 1957 39% #1 10% business in that core market picked up momentum in BENELUX 1970 52% #1 19% 2003. For the first time in years, it gained category Source; Information Resources, Inc., Food, Drug, and Mass share (+1.0 point). The innovation included the Channels, Latest 52-week period ended December 2003. relaunch of Kellogg’s Corn Flakes ®, using a foil inner bag to preserve freshness, and extending the brand with Kellogg’s Corn Flakes with Bananas. We also intro- duced Special K® Peach & Apricot and Crunchy Nut® Clusters, extensions of those two brands. Our calendar Europe: Regaining Share in Key Countries Value Share of RTE Cereal Category of consumer promotions was the most aggressive it had been in years. A themed cereal and a watch-in-the- 52 Weeks Change vs. 2003 Year Ago box insert were tied to the popular Simpsons® cartoon, UK 42.8% +1.0 and we ran promotions linked to Cartoon Network®, 44.2% +2.4 FRANCE Disney®, and the movie X-Men 2®. A weight-loss chal- lenge was again successful, as was a book offer and an Source; Information Resources, Inc. exercise-ball giveaway. We increased our advertising and made it better, especially on Frosties ®, Coco Pops®, Special K®, and Crunchy Nut ®. Meanwhile, we continue to expand our wholesome snacks business. We added Kellogg Company 13
    • line extensions and distribution to our existing brands, Latin America including new flavors of Cereal & Milk bars, Special K® Latin America remains our fastest growing region in the bars, Nutri-Grain® bars and Nutri-Grain® Minis, and world. We have leading category shares, a long-stand- Fruit‘N FibreTM bars. The U.K.’s results offer a great ing presence, and a strong local management team that example of what Volume to Value can do. is adept at managing through the volatility inherent in This same approach was taken in our other European that region. Per capita consumption of ready-to-eat markets, as well. We generated good growth in coun- cereal continues to grow, and yet remains well below tries like France, where our share of the ready-to-eat levels of developed markets. This points to sustainable cereal category rose more than 2 points, and in other category growth. Furthermore, rising disposable income markets like Spain and Italy, where cereal consumption and increased snacking suggests very attractive potential continues to grow. In each case, the gains were driven for our small, but rapidly growing wholesome snacks by better brand-building initiatives and more differenti- business in key markets of Latin America. ated innovation. Examples of brand building and inno- vations in Europe abound, both in cereal and in whole- Latin Am. All Other some snacks. We continued to roll out Special K® bars U.S. Retail Cereal into new markets, and we successfully launched new Special K® cereal flavors like Chocolate and Peach & Apricot. Reformulations, line extensions, and better Europe advertising have driven our Kellogg’s Extra® brand across Continental Europe. U.S. Retail Snacks In 2004, Kellogg Europe should again generate local- U.S. Other currency sales growth. Increased investment in brand % of KELLOGG NET SALES building and innovation should continue to grow cere- al sales in key markets, and we will continue to expand In 2003, Kellogg Latin America posted net sales our wholesome snacks business across the region. All growth of 2% in U.S. dollars, held back by currency the while, our emphasis will be on continuously devaluation. In local currencies, our growth was an improving execution. impressive 13% driven by both price/mix gains and tonnage. Both cereal and wholesome snacks posted double-digit growth. Mexico is by far our largest market in Latin America, and Kellogg de Mexico turned in another standout per- formance in 2003. Despite heavy competition from price brands and bagged cereals, our cereal business held its leading share, and posted double-digit net sales Earning Our Stripes 14
    • growth in local currency. As usual, Mexico’s growth was Latin America: driven by brand building and innovation on core Net Sales Growth Gets Stronger brands. Zucaritas® was lifted by a strong advertising 13 and promotion campaign, and Special K® rose strongly amidst another weight-loss challenge campaign and 7 line extension. We added a cappuccino flavor to our 5 All-Bran® line, and we executed numerous popular inserts and other promotions. Meanwhile, our sales of wholesome snacks in Mexico nearly doubled versus the 2001 2002 2003 prior year. In this relatively new category, we leverage % Growth, Local Currency our powerful cereal brands to expand our portfolio, and we use a DSD distribution system to extend our product availability. In 2003, All-Bran® snack bars con- tinued their strong growth, and we launched a handful Latin America: of Disney® snack products. Per Capita Consumption Ready-To-Eat Cereal In 2004, our Latin America business should again post Puerto Rico 4.3 solid sales growth, despite inevitable economic, curren- Mexico 1.5 cy, and political volatility in several markets. Cereal sales Costa Rica 1.1 should continue to benefit from new products, advertis- Panama 1.0 Guatemala ing, and consumer promotion, and we will continue to 0.7 Venezuela 0.5 expand our wholesome snacks business. Honduras 0.4 Chile 0.5 Argentina 0.2 El Salvador 0.5 Colombia 0.3 Dominican Republic 0.2 Brazil 0.1 Ecuador 0.2 Latin America 0.5 US 4.6 Total World 1.1 Kilograms Mexico: Leading Share The International Foodservice teams continued to earn Ready-To-Eat Cereal Category their stripes in 2003, posting a third consecutive year of significant sales growth. Competitors Key successes included Kellogg’s®cereals now being served in all McDonald’s® stores in Australia and New Zealand, Morningstar Farms® products making the 70% Kellogg menu in Subway® restaurants in Canada, and our UK Foodservice team being appointed category leaders in both the cereal and snack categories with the market’s three largest contract catering companies. Source: Nielsen Retail Index, Rolling 52 weeks, December, 2003 Good momentum and strong execution should mean continued growth in 2004. Kellogg Company 15
    • All Other Areas In Australia, cereal sales were aided by favorable price/mix, and by the launch of Special K® Peach & Apricot and a Simpsons®-themed cereal. Brand-building Our other international markets encompass Canada activities included a successful on-pack CD promotion and Australia, two of our largest markets, and Asia. In on Nutri-Grain® cereal and an effective advertising cam- 2003, this group of markets collectively posted sales paign behind our Sultana BranTM brand. Our snacks growth of nearly 18%, or 4% in local currencies. These business in Australia continued to post exceptional markets made strong progress on the Volume to Value growth, as we extend our portfolio and our distribution. metrics in 2003, enhancing their financial performance. Asia also posted solid growth. In Japan, growth was All driven by All-Bran®, behind an effective advertising Other campaign, and by a new Disney cereal. In Korea, a Lion King® on-pack CD and the launch of a new Almond U.S. Retail Cereal Latin Am. Flake cereal flavor led to good growth. Other International Areas: Europe Accelerated Growth 4% 2% U.S. Retail -2% Snacks U.S. Other % of KELLOGG NET SALES 2001 2002 2003 Year-Over-Year % Change, In Canada, we experienced growth in both cereal and Local Currencies snacks. Cereal growth was led by new advertising pro- grams on Special K ® and All Bran ®, proven campaigns Each of these regions and markets will focus on Volume on Kellogg’s Frosted Flakes® and Froot Loops® and new to Value in 2004. We should continue to build momen- product launches such as Hunny B’sTM, Tony’s Cinnamon tum in our innovation pipeline and our consumer promo- Frosted FlakesTM and a Scooby Doo-themed cereal. tions, allowing us to grow our cereal sales in the highly competitive Canadian and Australian markets, with faster The healthy snacks business in Canada was driven by growth coming from Asia. Our wholesome snacks busi- Special K TM bars and the introduction of new products, nesses in Australia and Canada should once again such as Rice Krispies Squares ® Bars with Cadbury® expand, taking advantage of favorable trends in snacking. Chocolate and Nutri-Grain Mini Granola Bites TM. Earning Our Stripes 16
    • IMPROVING OUR PROFITABILITY To be able to afford increased brand building and These factors are expected to raise our gross profit innovation investment, we need to improve our margin over time, even as we continue to face rising gross profit margin and control our overhead commodity, fuel, and benefits costs. Importantly, we expenses. In 2003, we improved our underlying prof- plan to use this improved profitability to reinvest in itability enough to invest for the future. While our our brands. When we refer to brand building, we reported gross profit margin declined modestly, this mean advertising and consumer promotion, not was largely due to investment. We incurred $70 mil- price discounting. In 2003, our brand-building lion of asset write-offs and other up-front costs relat- investment was increased at a strong double-digit ed to cost-savings initiatives; these are investments in rate, and we plan for this investment to again out- future profitability. We also increased the use of toys pace sales growth in 2004. in the box and other inserts, a form of consumer Our earnings growth in 2003 was of very high quali- promotion that is accounted for in cost of goods ty. It included the investment in brand building and sold. We faced higher costs in the form of commodi- cost-savings projects, as well as nearly $30 million of ties, fuel, and benefits, but we were able to offset other charges related to asset impairments and bond them with a combination of the following: repurchases that are not typical events. To post a • Increased net sales, which leveraged our fixed costs; strong earnings gain in the face of these signficant charges and investments suggests a very strong • A favorable mix shift toward our more profitable underlying profitability that can be used to drive products, thanks to the Volume to Value focus; growth in the future. • Synergies related to the Keebler acquisition, which reached their targeted level; • Ongoing productivity improvements, which we Gross Profit Margin have relentlessly pursued and achieved over the past several years. 45.0% 44.4% 44.2% Kellogg Company has 2001 2002 2003 a significant competi- % of Net Sales tive advantage in its global infrastructure. The decision to expand our business Investing in Our Business: internationally was Advertising Spending taken early in the $699 Company’s history and $589 was a far-sighted one. This scale allows us to take $519 advantage of global sourcing, decrease our input costs, transfer production and administrative functions between regions, and share best practices and ideas across all our markets. In 2003, our global packaging sourcing group, which has members around the 2001 2002 2003 world, instituted a broad program to coordinate the Millions sourcing of materials, adhesives, and cartons in many of our markets. This program is expected to dramati- cally improve efficency and save the Company millions Kellogg of dollars each year. Yet another way we are earning Company our stripes. 17
    • TURNING OUR PROFIT INTO CASH were growing. We expect to reduce core working Grow Net Earnings capital as a percent of sales again in 2004, albeit at Increase a more modest rate. Return on Invested Capital Disciplined Capital Expenditure Reduce Working MANAGE 6.0% Capital FOR 4.3% CASH 3.8% 3.7% 3.1% 2.8% Improve Financial Prioritize Flexibility Capital 1998 1999 2000 2001 2002 2003 Expenditure As % of Net Sales To create value for share owners, profit must be turned into cash. Our Manage for Cash principle has We’ve also remained extremely disciplined on capital the entire organization focused on doing just that. expenditure. In 2003, our capital expenditure was For example, in 2003, we reduced core working cap- approximately 3% of net sales, a level we believe is ital (12 months‘ average trade receivables plus inven- sustainable. Capital is not free, and this target tory, minus trade payables) as a percent of net sales ensures business discipline and higher returns on for the third consecutive year. This reduction of investment. When launching a new product, we look working capital has freed up millions of dollars of first to existing capacity. We seek ways to improve cash flow during those three years, even as our sales productivity, rather than simply purchasing new equip- ment. We expect to maintain this capital expenditure Fiscal 2003: Improving at 3% of net sales in 2004, as well. Working Capital 9.9% The result of these efforts has been strong cash flow 8.8% 8.7% 8.6% that has exceeded net income over each of the past 8.4% 8.2% three years. In 2004, we expect cash flow to again exceed net income. This strong cash flow allowed us to improve Dec. Dec. Mar. June Sept. Dec. our financial flexibility by paying down more than 2001 2002 2003 $550 million of debt in 2003, and to make another Core Working Capital cash contribution to our pension and retiree health- as % of Net Sales care benefit funds. In 2004, we will continue to pay * Based on last 12 months‘ average trade receivables and inventory, less trade payables, divided by net sales. Earning Our Stripes 18
    • down debt, but we will also use our cash flow in other ways. Last December, our Board of Directors approved an authorization to repurchase up to $300 million worth of Kellogg shares during 2004. We will also consider small, tack-on acquisitions, provided the valuation is attractive, and we can leverage our brands and supply chain. At Kellogg we recognize the critical importance of Improving Financial Flexibility diversity in our workforce and employee safety in $6.8 $6.2 our workplace. Success in enhancing diversity and $5.7 $5.2 employee safety will make Kellogg an even better company. In 2003, we took the additional step of formally including these initiatives in all individuals’ accountabilities for use in our annual performance March, 2001 December, December, December, reviews. This is another way we hope to earn our Keebler 2001 2002 2003 Acquisition stripes in the future. Outstanding Debt, in Billions As we increase our earnings (Volume to Value) and TM hold down our invested capital (Manage for Cash) our return on investment capital will continue to improve. This, in turn, improves our earnings, sus- taining the cycle. TM TM TM TM HELPING THE COMMUNITY At Kellogg, we are committed to giving back to our communities, and we proudly contribute to numerous local, national, and international charities. Our employ- ees contribute financially and with their time. Whether it is working to feed the hungry at a food pantry or building houses through Habitat For Humanity, we real- ize that we have an obligation to strengthen communi- ties. Our Company also recognizes this obligation through strong partnerships with local United Way organizations. In 2003, Kellogg and its people donated almost $2.9 million to local United Way campaigns in 22 U.S. communities. Our commitment to good citi- zenship also includes donations of food to hunger-relief United in Giving: Kellogg employees celebrate their record con- organizations around the world; in 2003, these dona- tribution to the United Way of Greater Battle Creek campaign. tions totaled more than $30 million. This $1.6 million contribution supports critical, community-based human services and includes a dollar-for-dollar company match of employee and retiree pledges. Kellogg Company 19
    • PROVIDING NUTRITION TO OUR CONSUMERS Rarely has there ever been so much nutrition news and information coming out at once. It can be very confusing. As recently as two years ago, we were told to avoid fats in general and saturated fats in particular. Then, last year, attention turned towards trans fatty acids, which had been used in many foods to replace saturated fats. We are fortunate to have the brand and product portfolio we do. Science supports the nutritional importance of whole grains and bran products. There are numerous studies that confirm that con- sumers who eat cereal for breakfast tend to have a lower body mass index than those who do not. Our wholesome snacks represent a healthier alternative evaluating our product line, looking for opportuni- to confectionery and other substitute products. We ties to selectively enhance certain products without are proud of our portfolio, and believe it offers a sacrificing taste and consumer acceptance. For wide enough selection of products and nutritional example, there may be opportunities to reduce or attributes that it can fit into any balanced diet and eliminate trans fatty acids, or to market products healthy lifestyle. that are low in carbohydrates, high in protein, or There is no question that obesity is reaching crisis low in calories. In summary, we will preserve our proportions in many countries around the world. reputation for providing wholesomeness, while giv- We can be part of the solution. We are currently ing consumers a choice. Earning Our Stripes 20
    • LIVING THE VALUES Every day, our employees demonstrate their commit- We Are Passionate About Our Business, ment to our corporate values. We take our culture seri- Our Brands And Our Food ously and provide ongoing training to constantly rein- • Show pride in our brands and heritage force our responsibilities to our customers, our commu- • Promote a positive, energizing, optimistic and fun nities, and to each other. This is nothing new to our environment Company; we have always followed these guiding prin- • Serve our customers and delight our consumers ciples in all our dealings. In 2002, we updated our val- through the quality of our products and services ues and instituted training programs that most of our • Promote and implement creative and innovative ideas management have attended. This program acts as a and solutions periodic reinforcement of our corporate values, across • Aggressively promote and protect our reputation the Company. We consider these values so important that we’ve again devoted to them a full page in our We Have The Humility And Hunger To Learn Annual Report. • Display openness and curiosity to learn from anyone, We Act With Integrity And Show Respect anywhere • Solicit and provide honest feedback without regard • Demonstrate a commitment to integrity and ethics to position • Show respect for and value all individuals for their • Personally commit to continuous improvement and diverse backgrounds, experience, styles, approaches be willing to change and ideas • Admit our mistakes and learn from them • Speak positively and supportively about team mem- • Never underestimate our competition bers when apart We Strive For Simplicity • Listen to others for understanding • Stop processes, procedures and activities that slow us • Assume positive intent down or do not add value • Work across organizational boundaries/levels and We Are All Accountable break down internal barriers • Accept personal accountability for our own actions • Deal with people and issues directly and avoid hidden and results agendas • Focus on finding solutions and achieving results, • Prize results over form rather than making excuses or placing blame We Love Success • Actively engage in discussions and support decisions • Achieve results and celebrate when we do once they are made • Help people to be their best by providing coaching • Involve others in decisions and plans that affect them and feedback • Keep promises and commitments made to others • Work with others as a team to accomplish results and win • Personally commit to the success and well being of teammates • Have a “can-do” attitude and drive to get the job done • Improve safety and health for employees and • Make people feel valued and appreciated embrace the belief that all injuries are preventable • Make the tough calls TM Kellogg Company TM TM TM 21 TM
    • Management’s Discussion and Analysis Kellogg Company and Subsidiaries Results of operations prior-year results. For the year ended December 28, 2002, our Company reported net earnings per diluted share of $1.75 versus Overview $1.16 in 2001. Results for 2001 were reduced by several charges Kellogg Company is the world’s leading producer of cereal and a and expense items, as presented in the table below. leading producer of convenience foods, including cookies, crackers, 2001 expense items affecting comparability with 2002 results toaster pastries, cereal bars, frozen waffles, and meat alternatives. Per share (basic Net earnings and diluted) Kellogg products are manufactured and marketed globally. In re- (millions except per share data) Debt extinguishment charge (a) $ 7.4 $ .02 cent years, our Company has been managed in two major divisions Restructuring charges, net of credits (b) 20.5 .05 - the United States and International - with International further Keebler integration impact (c) 46.2 .11 delineated into Europe, Latin America, Canada, Australia, and Asia. Amortization eliminated by SFAS No. 142 (d) 85.0 .21 While this historical organizational structure is the basis of the op- Cumulative effect of accounting change (e) 1.0 .— erating segment data presented in this report, we recently reorgan- (a) Net earnings for 2001 include a debt extinguishment charge of $7.4 (net of tax benefit of $4.2), which was originally clas- ized our geographic management structure to North America, sified as an extraordinary loss. Under SFAS No. 145, which we adopted in 2003, generally, debt extinguishments are no longer classified as extraordinary items. Accordingly, the extraordinary loss for 2001 has been reclassified to Earnings Europe, Latin America, and Asia Pacific, and we will begin reporting before cumulative effect of accounting change. on this basis for 2004. (b) Operating profit for 2001 includes restructuring charges related to implementing our operating principles and preparing Kellogg for the Keebler integration. Refer to Note 3 within Notes to Consolidated Financial Statements for further information. Our strategy is to manage our Company for steady, consistent growth (c) Sales and operating profit for 2001 were reduced by the financial impact of Keebler integration activities. Refer to the dis- cussion of 2002 and 2001 results on page 24 for further information. and an attractive dividend yield, which together should provide strong (d) Under SFAS No. 142, which we adopted in 2002, virtually all of our intangibles amortization expense was eliminated in total return for shareholders. We achieve this sustainability through a post-2001 fiscal years. Refer to Notes 1 and 15 within Notes to Consolidated Financial Statements for further information. focused strategy to grow our cereal business, expand our snacks busi- (e) Net earnings for 2001 include a charge for the cumulative effect of accounting change related to the adoption of SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities.” Refer to Note 1 within Notes to Consolidated Financial ness, and pursue selective growth opportunities. We support our busi- Statements for further information. ness strategy with a financial model that emphasizes sales dollars over Net sales and operating profit shipment volume (Volume to Value), as well as cash flow and return on invested capital (Manage for Cash). We believe the success of our strat- 2003 compared to 2002 egy and financial principles are reflected in the steady improvement of The following tables provide an analysis of net sales and operating our Company’s financial results over the past three years. profit performance for 2003 versus 2002: During 2001, our Company experienced a significant transition re- Other lated to the acquisition and first phase of the integration of United Latin operating Consoli- States Europe America (b) Corporate dated (dollars in millions) Keebler Foods Company (the “Keebler acquisition”), as well as the 2003 net sales $5,629.3 $1,734.2 $645.7 $802.3 $ — $8,811.5 fundamental refocus of our business model. While net earnings 2002 net sales $5,525.4 $1,469.8 $631.1 $677.8 $ — $8,304.1 were dampened by increased interest and tax expense, and other % change - 2003 vs. 2002: short-term financial impacts of this transition, we achieved several Volume (tonnage) -.2% -.6% 6.6% -3.4% — — important goals during 2001: increased dollar share in the U.S. ce- Pricing/mix 3.2% 3.4% 6.7% 7.1% — 3.8% Subtotal - internal business 3.0% 2.8% 13.3% 3.7% — 3.8% real category; pricing and mix-related improvements in net sales; Dispositions (a) -1.1% — — — — -.8% expansion of gross profit margin; and the highest cash flow (net Foreign currency impact — 15.2% -11.0% 14.7% — 3.1% cash provided from operating activities less expenditures for prop- Total change 1.9% 18.0% 2.3% 18.4% — 6.1% erty additions) to that date in our Company’s history. In 2002, our Company accelerated its performance in several key Other United Latin operating Consoli- metrics: internal sales growth, expansion of gross profit margin, and States Europe America (b) Corporate dated (dollars in millions) continued strong cash flow. We believe improved execution, in- 2003 operating profit $1,055.0 $ 279.8 $168.5 $140.0 ($99.2) $1,544.1 creased brand-building investment, better innovation, and a focus 2002 operating profit $1,073.0 $ 252.5 $170.1 $104.0 ($91.5) $1,508.1 on value over volume were important drivers of this performance. % change — 2003 vs. 2002: Internal business -.8% -2.1% 11.4% 18.5% -8.5% 1.1% In 2003, our Company continued to demonstrate business mo- Dispositions (a) -.9% — — — — -.6% mentum with solid financial performance, achieving broad-based Foreign currency impact — 12.9% -12.3% 16.2% — 1.9% sales and operating profit growth, despite substantial reinvest- Total change -1.7% 10.8% -.9% 34.7% -8.5% 2.4% ment in brand building and productivity initiatives. (a) Impact of results for the comparable 2002 periods prior to divestiture of the Bake-Line private label business in April 2002 and additional private label operations in Janurary 2003. Refer to Note 2 within Notes to Consolidated Financial For the year ended December 27, 2003, our Company reported Statements for further information. net earnings per diluted share of $1.92, a 10% increase over (b) Includes Canada, Australia, and Asia. Earning Our Stripes 22
    • During 2003, we achieved consolidated internal net sales growth value of a contract-based intangible asset. The asset is associated of 3.8%, against a strong year-ago growth rate of 4.0%. U.S. net with a long-term licensing agreement principally in the United sales in the retail cereal channel increased approximately 7%, as States and the decline in value was based on the proportionate the combination of brand-building activities and innovation drove decline in estimated future cash flows to be derived from the con- higher tonnage and improved mix. A modest U.S. cereal price in- tract versus original projections. crease taken early in 2003 also contributed to the sales increase. To position our Company for sustained, reliable growth in earnings Excluding the impact of private-label business divestitures during and cash flow for the long term, we are undertaking a series of the past year, internal net sales of our U.S. snacks business (which cost-saving initiatives. Some of these initiatives are still in the includes cereal bars and other wholesome snacks, cookies, and planning stages and individual actions are being announced as crackers) were approximately even with the prior year. The 2003 plans are finalized. Major actions implemented in 2003 include a sales performance of our U.S. snacks business was negatively im- wholesome snack plant consolidation in Australia, manufacturing pacted by our strategic decisions to discontinue a low-margin con- capacity rationalization in the Mercosur region of Latin America, tract manufacturing relationship in May 2003 and to accelerate and plant workforce reduction in Great Britain. Additionally, manu- stock-keeping unit (SKU) rationalization, beginning in the second facturing and distribution network optimization efforts in the quarter of 2003. In addition to these strategic factors, our U.S. Company’s U.S. snacks business have been ongoing since the snacks business experienced a decline in cookie sales, which we Company’s acquisition of Keebler in 2001. Taking into account all believe is a result of aggressive price promotion by competitors, a of these major initiatives, plus other various plant productivity and relative lack of innovation and brand-building activities, and cur- overhead reduction projects, the Company recorded total charges rent trends in consumer preferences. While overshadowed during of approximately $71 million during 2003, comprised of $40 mil- 2003, we believe continued growth in wholesome snacks and sta- lion in asset write-offs, $8 million for pension settlements, and ble performance in crackers should offset persisting softness in $23 million in severance and other cash exit costs. These charges cookie sales during 2004. Internal net sales for our other U.S. busi- were recorded principally in cost of goods sold and impacted the nesses (which include frozen waffles, toaster pastries, natural and Company’s operating segments as follows (in millions): U.S.-$36, vegetarian foods, and food-away-from-home channels) collectively Europe-$21, Latin America-$8, all other-$6. (Refer to Note 3 increased approximately 3%. within Notes to Consolidated Financial Statements for further in- Total international net sales increased over 5% in local currencies, formation on these initiatives.) with growth in all geographic segments. Our European operating The cost-saving initiatives that we are undertaking could poten- segment exhibited strong sales and category share performance tially result in a yet-undetermined amount of exit costs and as- throughout 2003, benefiting from increased brand-building invest- set write-offs during 2004. Additionally, we expect to continue ment and innovation activities across the region. Internal net sales with manufacturing network optimization efforts in our U.S. growth in Latin America was driven by a strong performance by snacks business. our Mexican business unit in both cereal and snacks. Our other 2002 compared to 2001 non-U.S. segments, which include Canada, Australia, and Asia, col- lectively delivered solid internal net sales growth, as significant The following tables provide an analysis of net sales and operating pricing and mix improvements offset the tonnage impact of dis- profit performance for 2002 versus 2001: continuing product lines in Australia and Asia in late 2002. Other United Latin operating Consoli- Consolidated internal operating profit increased only 1% during States Europe America (e) Corporate dated (dollars in millions) 2003, as significant charges related to cost-saving initiatives par- 2002 net sales $5,525.4 $1,469.8 $631.1 $677.8 $ — $8,304.1 tially offset solid underlying business growth. U.S. internal operat- 2001 net sales $4,889.4 $1,360.7 $650.0 $648.3 $ — $7,548.4 ing profit declined nearly 1%, absorbing the majority of the % change - 2002 vs. 2001: Volume (tonnage) .3% — .1% -3.2% — -.2% charges, as well as higher commodity, energy, and employee bene- Pricing/mix 3.8% 2.4% 6.6% 5.6% — 4.2% fit costs. International operating profit increased over 6% on a lo- Subtotal - internal business 4.1% 2.4% 6.7% 2.4% — 4.0% cal currency basis. Brand-building expenditures increased signifi- Integration impact (a) .4% — — — — .2% cantly in all core markets, reaching a double-digit growth rate on a Acquisitions & dispositions (b) 8.5% — — — — 5.5% consolidated basis. Foreign currency impact — 5.6% -9.6% 2.2% — .3% Total change 13.0% 8.0% -2.9% 4.6% — 10.0% During 2003, we recorded in selling, general, and administrative expense an impairment loss of $10 million to reduce the carrying Kellogg Company 23
    • direct costs for employee incentive and retention programs, em- Other ployee separation and relocation benefits, and consulting con- United Latin operating Consoli- States Europe America (e) Corporate dated (dollars in millions) tracts, and 3) impairment and accelerated depreciation of software 2002 segment operating profit $1,073.0 $ 252.5 $ 170.1 $104.0 ($91.5) $1,508.1 assets being abandoned due to the conversion of our U.S. busi- 2001 operating profit $745.5 $245.8 $170.7 $101.6 ($95.7) $1,167.9 ness to the SAP system. We estimate that these activities reduced Restructuring charges (c) 29.5 (.2) (.1) 1.4 2.7 33.3 net sales by $17.8 million, increased cost of goods sold by $5.6 Amortization (d) 100.5 — .5 .1 2.5 103.6 million, and increased selling, general, and administrative expense 2001 segment operating profit $ 875.5 $ 245.6 $ 171.1 $103.1 ($90.5) $1,304.8 % change - 2002 vs. 2001: by $51.0 million, for a total 2001 operating profit reduction of Internal business 10.6% -3.1% 4.9% -1.4% -10.5% 6.4% $74.4 million. Integration impact (a) 8.7% — — — 9.4% 6.3% Acquisitions & dispositions (b) 3.3% — — — — 2.3% Margin performance Foreign currency impact — 5.9% -5.5% 2.2% -.1% .6% Margin performance is presented in the following table. Total change 22.6% 2.8% -.6% .8% -1.2% 15.6% (a) Impact of Keebler integration activities during 2001. Refer to discussion of results of operations in paragraphs following Change vs. prior year (pts.) these tables for further information. 2003 2002 2001 2003 2002 (b) Impact of results for the first twelve weeks of 2002 from Keebler Foods Company, acquired in March 2001; and impact Gross margin 44.4% 45.0% 44.2% -.6 .8 of results for the comparable 2001 period subsequent to the April 2002 divestiture of the Bake-Line private label busi- SGA% (a) -26.9% -26.8% -28.3% -.1 1.5 ness. Refer to Note 2 within Notes to Consolidated Financial Statements for further information. Restructuring charges — — -.4% — .4 (c) Operating profit for 2001 included restructuring charges related to implementing our operating principles and preparing Kellogg for the Keebler integration. Refer to Note 3 within Notes to Consolidated Financial Statements for further informa- Operating margin 17.5% 18.2% 15.5% -.7 2.7 tion. (a) Selling, general, and administrative expense as a percentage of net sales. (d) Pro forma impact of amortization eliminated by SFAS No. 142. Refer to Note 1 within Notes to Consolidated Financial Statements for further information. The 2003 gross margin was unfavorably impacted by significant (e) Includes Canada, Australia, and Asia. asset write-offs and exit costs related to cost-saving initiatives; During 2002, we achieved strong internal sales growth of 4% on higher commodity, energy, and employee benefit costs; and an in- a consolidated basis, resulting primarily from pricing and mix im- crease in package-related promotional costs. These unfavorable provements in all operating segments. U.S. net sales in the retail factors were mitigated by the favorable impact of operating lever- cereal business increased approximately 6% and total interna- age, pricing and mix improvements, and productivity savings, re- tional sales increased over 3% in local currencies. Excluding the sulting in only a 60 basis point decline in gross margin versus the impact of acquisitions, divestitures, and Keebler integration activi- prior year. The SGA% was approximately even with the prior year, ties, internal net sales in the U.S. retail snacks business were ap- as significant increases in brand-building and innovation expendi- proximately even with the prior year, as a double-digit increase in tures were offset by overhead savings. sales of our wholesome snack products offset a decline in cookie The 2002 gross margin improvement was attributable primarily to and cracker sales. We believe this decline was primarily as a result higher average pricing, improved mix, operating leverage, and cost of weak consumption in the cookie and cracker categories savings related to the Keebler acquisition. Our 2002 gross margin throughout the year and our decision to cancel an end-of-year was also favorably impacted by recognition of a $16.9 million cur- sales force incentive in order to improve efficiencies in our direct tailment gain related to a change in certain retiree health care store door (DSD) delivery system. plans, largely offset by asset impairment losses, an increase in During 2002, consolidated and U.S. internal operating profit in- package-related promotional costs, and costs and asset write-offs creased approximately 6% and 11%, respectively. Total interna- associated with various ongoing supply chain efficiency initiatives. tional local currency operating profit was approximately even with The 2002 SGA% was 150 basis points lower than the prior year, the prior year, held down by a double-digit increase in marketing due principally to our adoption of SFAS No. 142 on January 1, investment to drive core market sales growth. 2002, which eliminated most of our intangibles amortization ex- pense in post-2001 years. Cost of goods sold for 2002 includes an impairment loss of $5 million related to our manufacturing facility in China, representing Interest expense a decline in real estate market value subsequent to an original im- pairment loss recognized for this property in 1997. The Company On March 26, 2001, we acquired Keebler Foods Company in a completed a sale of this facility in late 2003, and the carrying cash transaction valued at $4.56 billion, which was financed value of the property approximated the net sales proceeds. through a combination of short-term and long-term debt. As a re- sult of this significant debt issuance, interest expense increased During 2001, sales and operating profit were reduced by the fi- dramatically in 2001 versus historical periods and again in 2002, nancial impact of Keebler integration activities (“integration im- due to the extra quarterly period of interest on Keebler acquisition- pact”). This integration impact consisted primarily of 1) the sales related debt. However, interest expense began to decline in 2003 and gross profit effect of lowering trade inventories to transfer our as a result of continuous pay-down of debt balances throughout snack foods to Keebler’s DSD system during the second quarter, 2) Earning Our Stripes 24
    • 2002 and 2003 and lower short-term market rates of interest. single-event benefits. We expect an ongoing rate for 2004 of Since the acquisition of Keebler in early 2001, our Company has approximately 35%. paid down over $1.6 billion of debt, even early-retiring $172.9 Liquidity and capital resources million of long-term debt in December 2003. The early retirement premium of $16.5 million, which primarily represents accelerated Our principal source of liquidity is operating cash flow resulting interest, is included in 2003 interest expense. from net earnings, supplemented by borrowings for major ac- quisitions and other significant transactions. This cash-generat- (dollars in millions) Change vs. prior year 2003 2002 2001 2003 2002 ing capability is one of our fundamental strengths and provides Reported interest expense $371.4 $391.2 $351.5 us with substantial financial flexibility in meeting operating and Amounts capitalized – 1.0 2.9 investing needs. Gross interest expense $371.4 $392.2 $354.4 -5.3% 10.7% Our measure of cash flow is defined as net cash provided by operat- We currently expect total-year 2004 interest expense to be re- ing activities reduced by expenditures for property additions. We use duced to approximately $320 million, as we continue to pay down this measure of cash flow to focus management and investors on the our debt balances. amount of cash available for debt repayment, dividend distributions, acquisition opportunities, and share repurchases. Our cash flow met- Other income (expense), net ric is reconciled to GAAP-basis operating cash flow as follows: Other income (expense), net includes non-operating items such as (dollars in millions) Change vs. prior year interest income, foreign exchange gains and losses, charitable do- 2003 2002 2001 2003 2002 nations, and gains on asset sales. Other income (expense), net for Net cash provided by operating activities $1,171.0 $999.9 $1,132.0 2003 includes a credit of approximately $17 million related to fa- Additions to properties (247.2) (253.5) (276.5) vorable legal settlements; a charge of $8 million for a contribution Cash flow $ 923.8 $746.4 $ 855.5 23.8% -12.8% to the Kellogg’s Corporate Citizenship Fund, a private trust estab- As a result of stronger than expected cash flow in both 2003 and lished for charitable giving; and a charge of $6.5 million to recog- 2002, we made voluntary contributions to several of our major nize the impairment of a cost-basis investment in an e-commerce pension and retiree health care plans. The after-tax impact of these business venture. Other income (expense), net for 2002 consists contributions reduced cash flow by approximately $37 million in primarily of a $24.7 million credit related to legal settlements, of 2003 and $254 million in 2002. After adjusting for these differ- which $16.5 million was received in the first quarter with the re- ences, 2003 cash flow was within $40 million of 2002 cash flow, mainder received throughout subsequent quarters. as the higher earnings in 2003 were overshadowed by extremely strong working capital improvements in 2002. Income taxes The fourth quarter of 2003 marked the tenth consecutive quarter in Our consolidated effective tax rate has benefited from accounting which our Company has achieved sequential improvement in the ra- changes, tax planning initiatives, and favorable audit closures over tio of core working capital (inventory and trade receivables less the past several years, declining from approximately 40% in 2001 trade payables) to net sales. For the year ended December 27, 2003, to less than 33% in 2003. The resulting tax savings have been average core working capital as a percentage of sales was 8.2%, reinvested, in part, in cost-saving programs, brand-building expen- compared to 8.8% for 2002 and 9.9% for 2001. For 2004, we ex- ditures, and other growth initiatives. pect continuing but more modest improvement in our core working Change vs. prior year (pts.) capital metric. Expenditures for property additions represented 2.8% 2003 2002 2001 2003 2002 of 2003 net sales compared with 3.1% in 2002 and 3.7% in 2001. Effective income tax rate 32.7% 37.0% 40.1% -4.3 -3.1 For 2004, expenditures for property additions are currently expected The effective income tax rate for 2001 of approximately 40% re- to remain at approximately 3% of net sales and cash flow (as de- flected the impact of the Keebler acquisition on nondeductible fined) is expected to exceed the amount of net earnings. goodwill and the level of U.S. tax on foreign subsidiary earnings. Despite significant voluntary contributions in 2002, several of our As a result of our adoption of SFAS No. 142 on January 1, 2002 pension plans experienced shortfalls in market values of trust as- (refer to Note 1 within Notes to Consolidated Financial sets versus the year-end 2002 accounting measurement of accu- Statements), goodwill amortization expense – and the resulting mulated obligation. As a result of this condition, we were required impact on the effective income tax rate – has been eliminated in to record in our year-end 2002 balance sheet an incremental re- periods subsequent to adoption. Accordingly, the 2002 effective duction in equity of approximately $306 million. Due to market income tax rate was reduced to 37%. gains and incremental funding during 2003 (net of increased obli- Due primarily to the implementation of various tax planning ini- gations), our plan position improved slightly at year-end 2003, and tiatives and audit closures, our 2003 effective income tax rate we reversed approximately $48 million of this equity charge. These was lowered to 32.7%, which includes over 200 basis points of balance sheet adjustments had no effect on our earnings and we Kellogg Company 25
    • do not expect them to impact our liquidity, capital resources, or our Consolidated Financial Statements for further information on account- ability to meet current debt covenants and maintain credit ratings. ing policies related to derivative financial and commodity instruments. To offset issuances under employee benefit programs, our Board of Foreign exchange risk Directors authorized management to repurchase up to $250 mil- Our Company is exposed to fluctuations in foreign currency cash lion of Kellogg common stock during 2003 and up to $150 million flows related to third-party purchases, intercompany loans and in 2002. Under these authorizations, we paid $90 million during product shipments, and nonfunctional currency denominated 2003 for approximately 2.9 million shares and $101 million during third-party debt. Our Company is also exposed to fluctuations in 2002 for approximately 3.1 million shares. We funded this repur- the value of foreign currency investments in subsidiaries and cash chase program principally by proceeds from employee stock option flows related to repatriation of these investments. Additionally, our exercises. For 2004, our Board of Directors has authorized stock Company is exposed to volatility in the translation of foreign cur- repurchases for general corporate purposes up to $300 million. rency earnings to U.S. Dollars. Primary exposures include the U.S. We have repaid over $1.6 billion of debt originally issued for the Dollar versus the British Pound, Euro, Australian Dollar, Canadian Keebler acquisition, reducing our total debt balance from approxi- Dollar, and Mexican Peso, and in the case of inter-subsidiary trans- mately $6.8 billion at March 2001 to $5.2 billion at year-end actions, the British Pound versus the Euro. We assess foreign cur- 2003. Some of the long-term debt has been redeemed prior to its rency risk primarily based on transactional cash flows and enter maturity date. In September 2002, we redeemed $300.7 million of into forward contracts, options, and currency swaps to reduce fluc- Notes due 2003, and in December 2003, we redeemed $172.9 tuations in net long or short currency positions. Forward contracts million of Notes due 2006. In January 2004, we repaid $500 mil- and options are generally less than 18 months duration. Currency lion of maturing seven-year Notes, initially replacing these Notes swap agreements are established in conjunction with the term of with short-term debt. underlying debt issuances. To partially replace other maturing debt, in June 2003, we issued The total notional amount of foreign currency derivative instru- $500 million of five-year 2.875% fixed rate U.S. Dollar Notes. ments at year-end 2003 was $749.2 million, representing a settle- These Notes were issued under an existing shelf registration state- ment obligation of $67.8 million. The total notional amount of for- ment. In conjunction with this issuance, we settled $250 million eign currency derivative instruments at year-end 2002 was $816.7 notional amount of forward interest rate contracts for a loss of million, representing a settlement obligation of $35.2 million. All of $11.8 million, which is being amortized to interest expense over these derivatives were hedges of anticipated transactions, transla- the term of the debt. Taking into account this amortization and is- tional exposure, or existing assets or liabilities, and mature within suance discount, the effective interest rate on these five-year 18 months, except for one currency swap transaction that matures Notes is 3.35%. in 2006. Assuming an unfavorable 10% change in year-end ex- change rates, the settlement obligation would have increased by We believe that we will be able to meet our interest and principal approximately $81.6 million in 2003 and $90.6 million in 2002. repayment obligations and maintain our debt covenants for the These unfavorable changes would generally have been offset by fa- foreseeable future, while still meeting our operational needs, in- vorable changes in the values of the underlying exposures. cluding the pursuit of selective growth opportunities, through our strong cash flow, our program of issuing short-term debt, and Interest rate risk maintaining credit facilities on a global basis. Our significant long- term debt issues do not contain acceleration of maturity clauses Our Company is exposed to interest rate volatility with regard to that are dependent on credit ratings. A change in the Company’s future issuances of fixed rate debt and existing and future is- credit ratings could limit its access to the U.S. short-term debt suances of variable rate debt. Primary exposures include move- market and/or increase the cost of refinancing long-term debt in ments in U.S. Treasury rates, London Interbank Offered Rates (LI- the future. However, even under these circumstances, we would BOR), and commercial paper rates. We currently use interest rate continue to have access to our credit facilities, which are in swaps and forward interest rate contracts to reduce interest rate amounts sufficient to cover the outstanding short-term debt bal- volatility and funding costs associated with certain debt issues, ance and debt principal repayments through 2004. and to achieve a desired proportion of variable versus fixed rate debt, based on current and projected market conditions. Market risks Note 7 within Notes to Consolidated Financial Statements pro- Our Company is exposed to certain market risks, which exist as a part vides information on our Company’s significant debt issues. The to- of our ongoing business operations and we use derivative financial tal notional amount of interest rate derivative instruments at year- and commodity instruments, where appropriate, to manage these end 2003 was $1.91 billion, representing a settlement obligation risks. Our Company, as a matter of policy, does not engage in trading of $2.1 million. The total notional amount of interest rate deriva- or speculative transactions. Refer to Note 12 within Notes to tive instruments at year-end 2002 was $1.83 billion, representing Earning Our Stripes 26
    • a settlement obligation of $6.0 million. Assuming average variable cordance with FIN 45 (refer to Note 1 within Notes to rate debt levels and issuances of fixed rate debt during the year, a Consolidated Financial Statements), we have recognized the fair one percentage point increase in interest rates would have in- value of guarantees associated with new loans to DSD route fran- creased interest expense by approximately $3.8 million in 2003 chisees issued beginning in 2003. These amounts are insignificant. and $2.3 million in 2002. Contractual obligations Price risk The following table summarizes future estimated cash payments Our Company is exposed to price fluctuations primarily as a result to be made under existing contractual obligations. Further infor- of anticipated purchases of raw and packaging materials. Primary mation on debt obligations is contained in Note 7 of Notes to exposures include corn, wheat, soybean oil, sugar, cocoa, and pa- Consolidated Financial Statements. Further information on lease perboard. We use the combination of long cash positions with obligations is contained in Note 6. suppliers, and exchange-traded futures and option contracts to re- Contractual obligations Payments due by period duce price fluctuations in a desired percentage of forecasted pur- 2009 and Total 2004 2005 2006 2007 2008 beyond (millions) chases over a duration of generally less than one year. The total Long-term debt $4,866.2 $578.1 $278.6 $ 904.4 $ 2.0 $501.4 $2,601.7 notional amount of commodity derivative instruments at year-end Capital leases 5.6 1.6 1.5 1.5 1.0 — — 2003 was $26.5 million, representing a settlement receivable of Operating leases 367.0 76.4 64.0 50.3 38.0 34.4 103.9 $.2 million. Assuming a 10% decrease in year-end commodity Purchase obligations (a) 369.9 191.5 68.3 43.8 30.4 29.6 6.3 prices, this settlement receivable would have converted to a settle- Other long-term (b) 97.0 13.0 5.4 5.5 6.9 7.4 58.8 ment obligation of approximately $2.7 million, generally offset by Total $5,705.7 $860.6 $417.8 $1,005.5 $78.3 $572.8 $2,770.7 a reduction in the cost of the underlying material purchases. The (a) Purchase obligations consist primarily of fixed commitments under various co-marketing agreements and to a lesser extent, of contracts for future delivery of commodities, packaging materials, and equipment, and service agreements. The total notional amount of commodity derivative instruments at amounts presented in the table do not include items already recorded in accounts payable or other current liabilities at year-end 2002 was $25.4 million, representing a settlement obli- year-end 2003, nor does the table reflect cash flows we are likely to incur based on our plans, but are not obligated to incur. Therefore, it should be noted that the exclusion of these items from the table could be a limitation in assessing gation of $.8 million. Assuming a 10% decrease in year-end com- our total future cash flows under contracts. modity prices, this settlement obligation would have increased by (b) Other long-term contractual obligations are those associated with noncurrent liabilities recorded within the Consolidated Balance Sheet at year-end 2003 and consist principally of projected commitments under deferred compensation approximately $1.6 million, generally offset by a reduction in the arrangements and other retiree benefits in excess of those provided within our broad-based plans. We do not have sig- nificant statutory or contractual funding requirements for our broad-based retiree benefit plans during the periods pre- cost of the underlying material purchases. sented and have not included these amounts in the table. Refer to Notes 9 and 10 within Notes to Consolidated Financial Statements for further information on these plans, including expected contributions for fiscal year 2004. In addition to the derivative commodity instruments discussed above, we use long cash positions with suppliers to manage a por- Significant tion of our price exposure. It should be noted that the exclusion of accounting estimates these positions from the analysis above may be a limitation in as- Our significant accounting policies, as well as recently adopted pro- sessing the net market risk of our Company. nouncements, are discussed in Note 1 of Notes to Consolidated Financial Statements. None of the pronouncements adopted in fiscal Off-balance sheet arrange- 2003 have had or are expected to have a significant impact on our ments and other obligations Company’s financial statements. Off-balance sheet arrangements Our critical accounting estimates, which require significant judg- Our off-balance sheet arrangements are generally limited to resid- ments and assumptions likely to have a material impact on our fi- ual value guarantees and secondary liabilities on operating leases nancial statements, are generally limited to those governing the of approximately $15 million and third party loan guarantees as amount and timing of recognition of consumer promotional expen- discussed in the following paragraph. ditures, the assessment of the carrying value of goodwill and other intangible assets, valuation of our pension and other postretirement Our Keebler subsidiary is guarantor on loans to independent con- benefit obligations, and determination of our income tax expense tractors for the purchase of DSD route franchises. At year-end and liabilities. In addition, administrative ambiguities concerning the 2003, there were total loans outstanding of $15.2 million to 413 Medicare Prescription Drug Improvement and Modernization Act of franchisees. Related to this arrangement, our Company has estab- 2003, as well as the current lack of FASB authoritative guidance in lished with a financial institution a one-year renewable loan facil- this area, presently result in uncertainty regarding the eventual fi- ity up to $17.0 million with a five-year term-out and servicing nancial impact of this legislative change on our Company. arrangement. We have the right to revoke and resell the route franchises in the event of default or any other breach of contract Promotional expenditures by franchisees. Revocations have been infrequent. Our maximum Our promotional activities are conducted either through the retail potential future payments under these guarantees are limited to trade or directly with consumers and involve in-store displays; fea- the outstanding loan principal balance plus unpaid interest. In ac- Kellogg Company 27
    • ture price discounts on our products; consumer coupons, contests, and other investments. We follow SFAS No. 87 “Employers’ and loyalty programs; and similar activities. The costs of these ac- Accounting for Pensions” and SFAS No. 106 “Employers’ tivities are generally recognized at the time the related revenue is Accounting for Postretirement Benefits Other Than Pensions” for recorded, which normally precedes the actual cash expenditure. the measurement and recognition of obligations and expense re- Therefore, the recognition of these costs requires management lated to our retiree benefit plans. Embodied in both of these stan- judgment regarding the volume of promotional offers that will be dards is the concept that the cost of benefits provided during re- redeemed by either the retail trade or consumer. These estimates tirement should be recognized over the employees’ active working are made using various techniques including historical data on life. Inherent in this concept, therefore, is the requirement to use performance of similar promotional programs. Differences be- various actuarial assumptions to predict and measure costs and tween estimated expense and actual redemptions are normally in- obligations many years prior to the settlement date. Major actuar- significant and recognized as a change in management estimate ial assumptions that require significant management judgment in a subsequent period. However, as our Company’s total promo- and have a material impact on the measurement of our consoli- tional expenditures represented nearly 30% of 2003 net sales, the dated benefits expense and accumulated obligation include the likelihood exists of materially different reported results if different long-term rates of return on plan assets, the health care cost trend assumptions or conditions were to prevail. rates, and the interest rates used to discount the obligations for our major plans, which cover employees in the United States, Intangibles United Kingdom, and Canada. Beginning in 2002, we follow SFAS No. 142 in evaluating impair- To conduct our annual review of the long-term rate of return on ment of goodwill and other intangible assets. Under this standard, plan assets, we work with third party financial consultants to model goodwill impairment testing first requires a comparison between expected returns over a 20-year investment horizon with respect to the carrying value and fair value of a reporting unit with associ- the specific investment mix of our major plans. The return assump- ated goodwill. Carrying value is based on the assets and liabilities tions used reflect a combination of rigorous historical performance associated with the operations of that reporting unit, which often analysis and forward-looking views of the financial markets includ- requires allocation of shared or corporate items among reporting ing consideration of current yields on long-term bonds, price-earn- units. The fair value of a reporting unit is based primarily on our ings ratios of the major stock market indices, and long-term infla- assessment of profitability multiples likely to be achieved in a the- tion. Our model currently incorporates a long-term inflation oretical sale transaction. Similarly, impairment testing of other in- assumption of 2.5% and an active management premium of 1% tangible assets requires a comparison of carrying value to fair (net of fees) validated by historical analysis. Although we review value of that particular asset. Fair values of non-goodwill intangi- our expected long-term rates of return annually, our benefit trust ble assets are based primarily on projections of future cash flows investment performance for one particular year does not, by itself, to be generated from that asset. For instance, cash flows related significantly influence our evaluation. Our expected rates of return to a particular trademark would be based on a projected royalty are generally not revised, provided these rates continue to fall stream attributable to branded product sales. These estimates are within a “more likely than not” corridor of between the 25th and made using various inputs including historical data, current and 75th percentile of expected long-term returns, as determined by anticipated market conditions, management plans, and market our modeling process. Our current assumed rate of return of 9.3% comparables. We periodically engage third party valuation consult- presently equates to approximately the 50th percentile expectation. ants to assist in this process. At December 27, 2003, intangible as- Any future variance between the assumed and actual rates of re- sets, net, were $5.1 billion, consisting primarily of goodwill, trade- turn on our plan assets is recognized in the calculated value of marks, and DSD delivery system associated with the Keebler plan assets over a five-year period and once recognized, experi- acquisition. While we currently believe that the fair value of all of ence gains and losses are amortized using a declining-balance our intangibles exceeds carrying value, materially different as- method over the average remaining service period of active plan sumptions regarding future performance of our snacks business or participants. Under this recognition method, a 100 basis point the weighted average cost of capital used in the valuations could shortfall in actual versus assumed performance of all of our plan result in significant impairment losses. assets in year one would result in an arising experience loss of ap- Retirement benefits proximately $20 million. The unfavorable impact on earnings in year two would be less than $1 million, increasing to approxi- Our Company sponsors a number of U.S. and foreign defined ben- mately $3 million in year five. Approximately 80% of this experi- efit employee pension plans and also provides retiree health care ence loss would be amortized through earnings at the end of year and other welfare benefits in the United States and Canada. Plan 20. Experience gains are recognized similarly. funding strategies are influenced by tax regulations. A substantial To conduct our annual review of health care cost trend rates, we majority of plan assets are invested in a globally diversified portfo- work with third party financial consultants to model our actual lio of equity securities with smaller holdings of bonds, real estate, Earning Our Stripes 28
    • claims cost data over a five-year historical period, including an in which we operate. Significant judgement is required in deter- analysis of pre-65 versus post-65 age group and other demo- mining our effective tax rate and in evaluating our tax positions. graphic trends. This data is adjusted to eliminate the impact of We establish reserves when, despite our belief that our tax return plan changes and other factors that would tend to distort the un- positions are supportable, we believe that certain positions are derlying cost inflation trends. Our initial health care cost trend rate likely to be challenged and that we may not succeed. We adjust is reviewed annually and adjusted as necessary, to remain consis- these reserves in light of changing facts and circumstances, such tent with our historical model, as well as any expectations regard- as the progress of a tax audit. Our effective income tax rate in- ing short-term future trends. Our 2004 initial trend rate of 8.5% cludes the impact of reserve provisions and changes to reserves compares to our recent five-year compound annual growth rate of that we consider appropriate. While it is often difficult to predict approximately 7%. Our initial rate is trended downward by 1% the final outcome or the timing of resolution of any particular tax per year, until the ultimate trend rate is reached. The ultimate matter, we believe that our reserves reflect the probable outcome trend rate is adjusted annually, as necessary, to approximate the of known tax contingencies. Favorable resolution would be recog- current economic view on the rate of long-term inflation plus an nized as a reduction to our effective tax rate in the year of resolu- appropriate health care cost premium. The current ultimate trend tion. Our tax reserves are presented in the balance sheet princi- rate of 4.5% is based on a long-term inflation assumption of pally within accrued income taxes. 2.5% plus a 2% premium. Medicare prescription benefits To conduct our annual review of discount rates, we use several In December 2003, the Medicare Prescription Drug Improvement published market indices with appropriate duration weighting to and Modernization Act of 2003 (the Act) became law. The Act in- assess prevailing rates on high quality debt securities. We also pe- troduces a prescription drug benefit under Medicare Part D, as riodically use third party financial consultants to model specific well as a federal subsidy to sponsors of retiree health care benefit AA-rated (or the equivalent in foreign jurisdictions) bond issues plans that provide a benefit that is at least actuarially equivalent against the expected settlement cash flows of our plans. The to Medicare Part D. At present, detailed regulations necessary to measurement dates for our benefit plans are generally consistent implement the Act have not been issued, including those that with our Company’s fiscal year end. Thus, we select discount rates would specify the manner in which actuarial equivalency must be to measure our benefit obligations that are consistent with market determined and the evidence required to demonstrate actuarial indices during December of each year. equivalency to the Secretary of Health and Human Services. Despite the above-described rigorous policies for selecting major Furthermore, the FASB has not yet issued authoritative guidance actuarial assumptions, we periodically experience differences be- on accounting for subsidies provided by the Act. To address this tween assumed and actual experience. For 2004, we currently ex- uncertainty, in January 2004, the FASB issued Staff Position (FSP) pect incremental amortization of experience losses of approxi- FAS 106-1, which permits plan sponsors to make a one-time elec- mately $20 million, arising largely from a decline in discount rates tion to defer recognition of the effects of the Act in accounting for at year-end 2003. Assuming actual future experience is consistent and making disclosures for postretirement benefit plans until au- with our current assumptions, annual amortization of accumulated thoritative guidance is issued. Accordingly, we have made this de- experience losses during each of the next several years would re- ferral election. However, when issued, this authoritative guidance main approximately level with the 2004 amount. could require us to change previously reported information. Based on current plan design, we believe certain health care benefit Income taxes plans covering a significant portion of our U.S. workforce are likely Our consolidated effective income tax rate is influenced by tax to qualify for this subsidy, which once recognized, could result in a planning opportunities available to us in the various jurisdictions moderate reduction in our annual health care expense. Kellogg Company 29
    • Future outlook flow and core working capital; capital expenditures; interest ex- pense; commodity and energy prices; and employee benefit plan Our long-term annual growth targets are low single-digit for inter- costs and funding. Forward-looking statements include predic- nal net sales, mid single-digit for operating profit, and high single- tions of future results or activities and may contain the words digit for net earnings per share. In general, we expect 2004 results “expect,” “believe,” “will,” “will deliver,” “anticipate,” “project,” to be consistent with these targets, despite several important chal- “should,” or words or phrases of similar meaning. Our actual re- lenges continuing from 2003: sults or activities may differ materially from these predictions. In ■ higher employee benefits expense; particular, future results or activities could be affected by factors ■ significant increases in the prices of certain grains, cocoa, other related to the Keebler acquisition, such as the substantial amount of debt incurred to finance the acquisition, which could, among ingredients, packaging, and energy; other things, hinder our ability to adjust rapidly to changing mar- ■ increased cost and reduced availability of certain types of ket conditions, make us more vulnerable in the event of a down- insurance; and turn, and place us at a competitive disadvantage relative to less- ■ economic volatility in Latin America. leveraged competitors. In addition, our future results could be affected by a variety of other factors, including: In addition to the continuing challenges listed above, the following important trends and uncertainties particular to 2004 should be ■ the impact of competitive conditions; noted: ■ the effectiveness of pricing, advertising, and promotional ■ Our 2004 fiscal year will include a 53rd week, which could add programs; approximately one percentage point of extra growth to our ■ the success of innovation and new product introductions; sales results. ■ the recoverability of the carrying value of goodwill and other ■ We expect another year of sales decline for the cookie portion intangibles; of our U.S. snacks business, due principally to category factors, ■ the success of productivity improvements and business aggressive SKU eliminations, and discontinuance of a custom transitions; manufacturing business during 2003. ■ commodity and energy prices, and labor costs; ■ We expect to continue to incur asset write-offs and exit costs associated with productivity initiatives throughout 2004. ■ the availability of and interest rates on short-term financing; ■ We expect full-year growth in brand-building expenditures to ■ actual market performance of benefit plan trust investments; exceed the rate of sales growth. ■ the levels of spending on systems initiatives, properties, ■ We expect our 2004 consolidated effective income tax rate to business opportunities, integration of acquired businesses, and be approximately 35% versus less than 33% in 2003. other general and administrative costs; ■ changes in consumer behavior and preferences; Forward-looking statements ■ the effect of U.S. and foreign economic conditions on items Our Management’s Discussion and Analysis and other parts of such as interest rates, statutory tax rates, currency conversion this Annual Report contain “forward-looking statements” with and availability.; projections concerning, among other things, our strategy, finan- cial principles, and plans; initiatives, improvements, and growth; ■ legal and regulatory factors; and, sales, gross margins, advertising, promotion, merchandising, ■ business disruption or other losses from war, terrorist acts, or brand-building expenditures, operating profit, and earnings per political unrest. share; innovation opportunities; exit plans and costs related to productivity initiatives; the impact of accounting changes and Forward-looking statements speak only as of the date they were FASB authoritative guidance to be issued; our ability to meet in- made, and we undertake no obligation to publicly update them. terest and debt principal repayment obligations; common stock repurchases or debt reduction; effective income tax rate; cash Earning Our Stripes 30
    • Kellogg Company and Subsidiaries Selected Financial Data (in millions, except per share data and number of employees) 2003 2002 2001 2000 1999 Operating trends Net sales $ 8,811.5 $ 8,304.1 $ 7,548.4 $ 6,086.7 $ 6,156.5 Gross profit as a % of net sales 44.4% 45.0% 44.2% 44.1% 45.2% Depreciation 359.8 346.9 331.0 275.6 273.6 Amortization 13.0 3.0 107.6 15.0 14.4 Advertising expense 698.9 588.7 519.2 604.2 674.1 Research and development expense 126.7 106.4 110.2 118.4 104.1 Operating profit (a) (d) 1,544.1 1,508.1 1,167.9 989.8 828.8 Operating profit as a % of net sales 17.5% 18.2% 15.5% 16.3% 13.5% Interest expense 371.4 391.2 351.5 137.5 118.8 Earnings before cumulative effect of accounting change (a) (b) (d) 787.1 720.9 474.6 587.7 338.3 Average shares outstanding: Basic 407.9 408.4 406.1 405.6 405.2 Diluted 410.5 411.5 407.2 405.8 405.7 Earnings per share before cumulative effect of accounting change (a) (b) (d): Basic 1.93 1.77 1.17 1.45 .83 Diluted 1.92 1.75 1.16 1.45 .83 Cash flow trends Net cash provided from operating activities $ 1,171.0 $ 999.9 $ 1,132.0 $ 880.9 $ 795.2 Capital expenditures 247.2 253.5 276.5 230.9 266.2 Net cash provided from operating activities reduced by capital expenditures (e) 923.8 746.4 855.5 650.0 529.0 Net cash used in investing activities (219.0) (188.8) (4,143.8) (379.3) (244.2) Net cash provided from (used in) financing activities (939.4) (944.4) 3,040.2 (441.8) (527.6) Interest coverage ratio (c) 5.1 4.8 4.5 9.4 7.9 Capital structure trends $10,230.8 Total assets $ 10,219.3 $10,368.6 $ 4,886.0 $ 4,808.7 Property, net 2,780.2 2,840.2 2,952.8 2,526.9 2,640.9 Short-term debt 898.9 1,197.3 595.6 1,386.3 521.5 Long-term debt 4,265.4 4,519.4 5,619.0 709.2 1,612.8 Shareholders’ equity 1,443.2 895.1 871.5 897.5 813.2 Share price trends $ 28-38 Stock price range $ 29-37 $ 25-34 $ 21-32 $ 30-42 Cash dividends per common share 1.010 1.010 1.010 .995 .960 Number of employees 25,250 25,676 26,424 15,196 15,051 (a) Operating profit for 2001 includes restructuring charges, net of credits, of $33.3 ($20.5 after tax or $.05 per share). Operating profit for 2000 includes restructuring charges of $86.5 ($64.2 after tax or $.16 per share). Operating profit for 1999 includes restructuring charges of $244.6 ($156.4 after tax or $.40 per share). Earnings before cumulative effect of accounting change for 1999 include disposition-related charges of $168.5 ($111.5 after tax or $.27 per share). (b) Earnings before cumulative effect of accounting change for 2001 exclude the effect of a charge of $1.0 after tax to adopt SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities.” Results for 2001 have been restated to reflect the adop- tion of SFAS No. 145 in 2003 concerning the income statement classification of losses from debt extinguishment. The net loss of $7.4 incurred in 2001, which was originally classified as an extraordinary loss, has been reclassified to Earnings before cumula- tive effect of accounting change. Refer to Note 1 within Notes to Consolidated Financial Statements for further information. (c) Interest coverage ratio is calculated based on earnings before interest expense, income taxes, depreciation, and amortization, divided by interest expense. (d) Results for 2001 include $103.6 ($85.0 after tax or $.21 per share) of amortization which has been eliminated by SFAS No. 142 on a pro forma basis. Amortization in pre-2001 years was insignificant. Refer to Note 1 within Notes to Consolidated Financial Statements for further information. Kellogg (e) The Company uses this non-GAAP financial measure to focus management and investors on the amount of cash available for debt repayment, dividend distributions, acquisition opportunities, and share repurchases. Company 31
    • Kellogg Company and Subsidiaries Consolidated Statement of Earnings 2003 2002 2001 except per share data) (millions, Net sales $8,811.5 $8,304.1 $7,548.4 Cost of goods sold 4,898.9 4,569.0 4,211.4 Selling, general, and administrative expense 2,368.5 2,227.0 2,135.8 Restructuring charges — — 33.3 Operating profit $1,544.1 $1,508.1 $1,167.9 Interest expense 371.4 391.2 351.5 Other income (expense), net (3.2) 27.4 (23.9) Earnings before income taxes and cumulative effect of accounting change $1,169.5 $1,144.3 $ 792.5 Income taxes 382.4 423.4 317.9 Earnings before cumulative effect of accounting change $ 787.1 $ 720.9 $ 474.6 Cumulative effect of accounting change (net of tax) — — (1.0) Net earnings $ 787.1 $ 720.9 $ 473.6 Per share amounts: Earnings before cumulative effect of accounting change: Basic $ 1.93 $ 1.77 $ 1.17 Diluted 1.92 1.75 1.16 Net earnings: Basic 1.93 1.77 1.17 Diluted 1.92 1.75 1.16 Refer to Notes to Consolidated Financial Statements. Consolidated Statement of Shareholders’ Equity Accumulated Capital in other Total Total Common stock excess of Retained Treasury stock comprehensive shareholders’ comprehensive shares amount par value earnings shares amount income equity income (millions) Balance, January 1, 2001 415.5 $103.8 $102.0 $ 1,501.0 9.8 ($ 374.0) ($ 435.3) $ 897.5 Net earnings 473.6 473.6 $ 473.6 Dividends (409.8) (409.8) Other comprehensive income (116.1) (116.1) (116.1) Stock options exercised and other (10.5) (.1) (1.0) 36.9 26.3 Balance, December 31, 2001 415.5 $103.8 $ 91.5 $ 1,564.7 8.8 ($ 337.1) ($ 551.4) $ 871.5 $ 357.5 Common stock repurchases 3.1 (101.0) (101.0) Net earnings 720.9 720.9 720.9 Dividends (412.6) (412.6) Other comprehensive income (302.0) (302.0) (302.0) Stock options exercised and other (41.6) (4.3) 159.9 118.3 Balance, December 28, 2002 415.5 $103.8 $ 49.9 $ 1,873.0 7.6 ($ 278.2) ($ 853.4) $ 895.1 $ 418.9 Common stock repurchases 2.9 (90.0) (90.0) Net earnings 787.1 787.1 787.1 Dividends (412.4) (412.4) Other comprehensive income 124.2 124.2 124.2 Stock options exercised and other (25.4) (4.7) 164.6 139.2 Balance, December 27, 2003 415.5 $103.8 $ 24.5 $2,247.7 5.8 ($203.6) ($729.2) $1,443.2 $911.3 Refer to Notes to Consolidated Financial Statements. Earning Our Stripes 32
    • Kellogg Company and Subsidiaries Consolidated Balance Sheet 2003 2002 except share data) (millions, Current assets Cash and cash equivalents $ 141.2 $ 100.6 Accounts receivable, net 754.8 741.0 Inventories 649.8 603.2 Other current assets 251.4 318.6 Total current assets $ 1,797.2 $ 1,763.4 Property, net 2,780.2 2,840.2 Other assets 5,653.4 5,615.7 Total assets $10,230.8 $10,219.3 Current liabilities Current maturities of long-term debt $ 578.1 $ 776.4 Notes payable 320.8 420.9 Accounts payable 703.8 619.0 Other current liabilities 1,163.3 1,198.6 Total current liabilities $ 2,766.0 $ 3,014.9 Long-term debt 4,265.4 4,519.4 Other liabilities 1,756.2 1,789.9 Shareholders’ equity Common stock, $.25 par value, 1,000,000,000 shares authorized Issued: 415,451,198 shares in 2003 and 2002 103.8 103.8 Capital in excess of par value 24.5 49.9 Retained earnings 2,247.7 1,873.0 Treasury stock at cost: 5,751,578 shares in 2003 and 7,598,923 shares in 2002 (203.6) (278.2) Accumulated other comprehensive income (loss) (729.2) (853.4) Total shareholders’ equity $ 1,443.2 $ 895.1 Total liabilities and shareholders’ equity $10,230.8 $10,219.3 Refer to Notes to Consolidated Financial Statements. Kellogg Company 33
    • Kellogg Company and Subsidiaries Consolidated Statement of Cash Flows 2003 2002 2001 (millions) Operating activities Net earnings $ 787.1 $ 720.9 $ 473.6 Adjustments to reconcile net earnings to operating cash flows: Depreciation and amortization 372.8 349.9 438.6 Deferred income taxes 74.8 111.2 71.5 Restructuring charges, net of cash paid — — 31.2 Other 76.1 67.0 (77.5) Pension and other postretirement benefit plan contributions (184.2) (446.6) (76.3) Changes in operating assets and liabilities 44.4 197.5 270.9 Net cash provided from operating activities $1,171.0 $999.9 $1,132.0 Investing activities Additions to properties ($ 247.2) ($ 253.5) ($ 276.5) Acquisitions of businesses — (2.2) (3,858.0) Dispositions of businesses 14.0 60.9 — Property disposals 13.8 6.0 10.1 Other .4 — (19.4) Net cash used in investing activities ($ 219.0) ($ 188.8) ($4,143.8) Financing activities Net increase (reduction) of notes payable, with maturities less than or equal to 90 days $ 208.5 ($226.2) ($ 154.0) Issuances of notes payable, with maturities greater than 90 days 67.0 354.9 549.6 Reductions of notes payable, with maturities greater than 90 days (375.6) (221.1) (365.6) Issuances of long-term debt 498.1 — 5,001.4 Reductions of long-term debt (956.0) (439.3) (1,608.4) Net issuances of common stock 121.6 100.9 26.4 Common stock repurchases (90.0) (101.0) — Cash dividends (412.4) (412.6) (409.8) Other (.6) — .6 Net cash provided from (used in) financing activities ($ 939.4) ($944.4) $3,040.2 Effect of exchange rate changes on cash 28.0 2.1 (1.0) $ 40.6 Increase (decrease) in cash and cash equivalents ($131.2) $ 27.4 Cash and cash equivalents at beginning of year 100.6 231.8 204.4 Cash and cash equivalents at end of year $ 141.2 $100.6 $ 231.8 Refer to Notes to Consolidated Financial Statements. Earning Our Stripes 34
    • Kellogg Company and Subsidiaries Notes to Consolidated Financial Statements Note 1 Accounting policies Goodwill and other intangible assets Basis of presentation The Company adopted SFAS No. 142 “Goodwill and Other Intangible Assets” on January 1, 2002. This standard provides ac- The consolidated financial statements include the accounts of counting and disclosure guidance for acquired intangibles. Under Kellogg Company and its majority-owned subsidiaries. this standard, goodwill and “indefinite-lived” intangibles are no Intercompany balances and transactions are eliminated. Certain longer amortized, but are tested at least annually for impairment. amounts in the prior-year financial statements have been reclassi- Goodwill impairment testing first requires a comparison between fied to conform to the current-year presentation. the carrying value and fair value of a reporting unit, including Beginning in 2002, the Company’s fiscal year normally ends on goodwill allocated to it. If carrying value exceeds fair value, good- the last Saturday of December and as a result, a 53rd week is will is considered impaired. The amount of impairment loss is added every fifth or sixth year. The Company’s 2002 and 2003 fis- measured as the difference between carrying value and implied cal years ended on December 28 and 27, respectively. The fair value of goodwill, which is determined in the same manner as Company’s 2004 fiscal year will end on January 1, 2005, and in- the amount of goodwill recognized in a business combination. clude a 53rd week. Prior to 2002, the Company had a calendar Impairment testing for non-amortized intangibles requires a com- year end. parison between the fair value and carrying value of the intangible asset. If carrying value exceeds fair value, the intangible is consid- Cash and cash equivalents ered impaired and is reduced to fair value. The Company uses vari- Highly liquid temporary investments with original maturities of less ous market valuation techniques to determine fair value of good- than three months are considered to be cash equivalents. The car- will and other intangible assets and periodically engages third rying amount approximates fair value. party valuation consultants for this purpose. Transitional impair- ment tests of goodwill and non-amortized intangibles were re- Inventories quired to be performed upon adoption of SFAS No. 142, with any Inventories are valued at the lower of cost (principally average) recognized impairment loss reported as the cumulative effect of an or market. accounting change in the first period of adoption. The Company was not required to recognize any impairment losses under these Property and other long-lived assets transitional tests. Fixed assets are recorded at cost and depreciated over estimated SFAS No. 142 also provides separability criteria for recognizing in- useful lives using straight-line methods for financial reporting and tangible assets apart from goodwill. Under these provisions, as- accelerated methods for tax reporting. Cost includes an amount of sembled workforce is no longer considered a separate intangible. interest associated with significant capital projects. Accordingly, effective January 1, 2002, the Company reclassified approximately $46 million from other intangibles to goodwill. The Company adopted Statement of Financial Accounting Refer to Note 15 for further information on the Company’s good- Standards (SFAS) No. 144 “Accounting for Impairment or Disposal will and other intangible assets. of Long-lived Assets” on January 1, 2002. This standard is gener- ally effective for the Company on a prospective basis. SFAS No. For periods prior to 2002, intangible assets were amortized on a 144 clarifies and revises existing guidance on accounting for im- straight-line basis over the estimated periods benefited, generally pairment of plant, property, and equipment, amortized intangibles, 40 years for goodwill and periods ranging from 5 to 40 years for and other long-lived assets not specifically addressed in other ac- other intangible assets. counting literature. Significant changes include 1) establishing cri- Revenue recognition and measurement teria beyond those previously specified in pre-existing literature for determining when a long-lived asset is held for sale, and 2) requir- The Company recognizes sales upon delivery of its products to ing that the depreciable life of a long-lived asset to be abandoned customers net of applicable provisions for discounts, returns, is revised. SFAS No. 144 also broadens the presentation of discon- and allowances. tinued operations to include a component of an entity (rather than Beginning January 1, 2002, the Company has applied the consen- only a segment of a business). sus reached by the Emerging Issues Task Force (EITF) of the FASB in Issue No. 01-9 “Accounting for Consideration Given by a Vendor Kellogg Company 35
    • to a Customer or a Reseller of the Vendor’s Products.” Under this 2003 2002 2001 consensus, generally, cash consideration is classified as a reduction Risk-free interest rate 1.89% 3.58% 4.57% of revenue, unless specific criteria are met regarding goods or Dividend yield 2.70% 2.92% 3.30% Volatility 25.75% 29.71% 28.21% services that the vendor may receive in return for this considera- Average expected term (years) 3.00 3.00 3.08 tion. Non-cash consideration is classified as a cost of sales. Fair value of options granted $4.75 $6.67 $5.05 As a result of applying this consensus, the Company has reclassi- Derivatives and hedging transactions fied promotional payments to its customers and the cost of con- sumer coupons and other cash redemption offers from selling, The Company adopted SFAS No. 133 “Accounting for Derivative general, and administrative expense (SGA) to net sales. The Instruments and Hedging Activities” on January 1, 2001. This Company has reclassified the cost of promotional package inserts statement requires all derivative instruments to be recorded on the and other non-cash consideration from SGA to cost of goods sold. balance sheet at fair value and establishes criteria for designation Prior-period financial statements have been reclassified to comply and effectiveness of hedging relationships. Upon adoption, the with this guidance. Company reported a charge to earnings of $1.0 million (net of tax benefit of $.6 million) and a charge to other comprehensive in- Advertising come of $14.9 million (net of tax benefit of $8.6 million) in order The costs of advertising are generally expensed as incurred and to recognize the fair value of derivative instruments as either as- are classified within SGA. sets or liabilities on the balance sheet. The charge to earnings re- lates to the component of the derivative instruments’ net loss that Stock compensation has been excluded from the assessment of hedge effectiveness. The Company currently uses the intrinsic value method prescribed Refer to Note 12 for further information. by Accounting Principles Board Opinion No. 25 “Accounting for During April 2003, the FASB issued SFAS No. 149 “Amendment of Stock Issued to Employees,” to account for its employee stock op- Statement 133 on Derivative Instruments and Hedging Activities.” tions and other stock-based compensation. Under this method, This statement amends and clarifies financial accounting and re- because the exercise price of the Company’s employee stock op- porting guidance for derivative instruments and hedging activities, tions equals the market price of the underlying stock on the date resulting primarily from decisions reached by the FASB Derivatives of the grant, no compensation expense is recognized. The table Implementation Group subsequent to the original issuance of below presents pro forma results for the current and prior years, as SFAS No. 133. This Statement is generally effective prospectively if the Company had used the alternate fair value method of ac- for contracts and hedging relationships entered into after June 30, counting for stock-based compensation, prescribed by SFAS No. 2003. The adoption of SFAS No. 149 has had minimal impact on 123 “Accounting for Stock-Based Compensation” (as amended by the Company, except that cash flows associated with certain deriv- SFAS No. 148). Under this pro forma method, the fair value of atives are now being classified in the financing rather than the op- each option grant was estimated at the date of grant using the erating section of the cash flow statement. Such derivatives are Black-Scholes option-pricing model and was recognized over the generally limited to net investment hedges and those used by the vesting period, generally two years. Pricing model assumptions are Company to reduce volatility in the translation of foreign currency presented below. Refer to Note 8 for further information on the earnings to U.S. Dollars. The impact of this classification change Company’s stock compensation programs. during 2003 was insignificant. 2003 2002 2001 (millions, except per share data) Recently adopted pronouncements Stock-based compensation expense net of tax: As reported $ 12.5 $ 10.7 $ 5.4 Exit activities Pro forma $ 42.1 $ 52.8 $ 29.1 Net earnings: The Company has adopted SFAS No. 146 “Accounting for Costs As reported $ 787.1 $ 720.9 $ 473.6 Associated with Exit or Disposal Activities,” with respect to exit or Pro forma $ 757.5 $ 678.8 $ 449.9 disposal activities initiated after December 31, 2002. This state- Basic net earnings per share: As reported $ 1.93 $ 1.77 $ 1.17 ment is intended to achieve consistency in timing of recognition Pro forma $ 1.86 $ 1.66 $ 1.11 between exit costs, such as one-time employee separation benefits Diluted net earnings per share: and contract termination payments, and all other costs. Under pre- As reported $ 1.92 $ 1.75 $ 1.16 existing literature, certain costs associated with exit activities were Pro forma $ 1.85 $ 1.65 $ 1.10 recognized when management committed to a plan. Under SFAS Earning Our Stripes 36
    • No. 146, costs are recognized when a liability has been incurred Extinguishment of debt under general concepts. For instance, under pre-existing literature, Net earnings for 2001 originally included an extraordinary loss of plant closure costs would be accrued at the plan commitment $7.4 million, net of tax benefit of $4.2 million ($.02 per share), re- date. Under SFAS No. 146, these costs would be recognized as clo- lated to the extinguishment of $400 million of long-term debt. sure activities are performed. These provisions could be expected Effective with its 2003 fiscal year, the Company adopted SFAS No. to have the general effect of delaying recognition of certain costs 145, a technical corrections pronouncement which in part, re- related to restructuring programs. However, adoption of this stan- scinds SFAS No. 4 “Reporting Gains and Losses from dard did not have a significant impact on the Company’s 2003 fi- Extinguishment of Debt.” Under SFAS No. 145, generally, debt ex- nancial results. Refer to Notes 2 and 3 for further information on tinguishments are no longer classified as extraordinary items. the Company’s exit activities during the periods presented. Accordingly, the extraordinary loss for 2001 has been reclassified to conform to the presentation for 2003 and subsequent years. Guarantees With respect to guarantees entered into or modified after Medicare prescription benefits December 31, 2002, the Company has applied guidance con- In December 2003, the Medicare Prescription Drug Improvement tained in FASB Interpretation No. 45 “Guarantor’s Accounting and and Modernization Act of 2003 (the Act) became law. The Act in- Disclosure Requirements for Guarantees, Including Indirect troduces a prescription drug benefit under Medicare Part D, as Guarantees of Indebtedness of Others.” This interpretation clarifies well as a federal subsidy to sponsors of retiree health care benefit the requirement for recognition of a liability by a guarantor at the plans that provide a benefit that is at least actuarially equivalent inception of the guarantee, based on the fair value of the non-con- to Medicare Part D. At present, detailed regulations necessary to tingent obligation to perform. Application of this guidance did not implement the Act have not been issued, including those that have a significant impact on the Company’s 2003 financial results. would specify the manner in which actuarial equivalency must be determined and the evidence required to demonstrate actuarial Variable interest entities equivalency to the Secretary of Health and Human Services. During January 2003, the FASB issued Interpretation No. 46 Furthermore, the FASB has not yet issued authoritative guidance “Consolidation of Variable Interest Entities,” which was later on accounting for subsidies provided by the Act. To address this amended by FIN 46-R issued in December 2003. Under previous uncertainty, in January 2004, the FASB issued Staff Position (FSP) practice, entities were included in consolidated financial state- FAS 106-1, which permits plan sponsors to make a one-time elec- ments based on controlling voting interests. Under this interpreta- tion to defer recognition of the effects of the Act in accounting for tion, previously unconsolidated entities (referred to as “variable in- and making disclosures for postretirement benefit plans until au- terest entities”) may be included in the consolidated financial thoritative guidance is issued. Accordingly, the Company has made statements of the “primary beneficiary” as a result of non-voting this deferral election. However, when issued, this authoritative financial interests that are established through contractual or guidance could require the Company to change previously re- other means. This interpretation is generally effective with the ported information. Based on current plan design, management Company’s fiscal 2004 first quarter. Management does not cur- believes certain health care benefit plans covering a significant rently believe these requirements are applicable to any existing fi- portion of the Company’s U.S. workforce are likely to qualify for nancial arrangement of the Company. this subsidy, which once recognized, could result in a moderate re- duction in our annual health care expense. Leasing Use of estimates In May 2003, the EITF reached consensus on Issue No. 01-8 “Determining Whether an Arrangement Contains a Lease.” This con- The preparation of financial statements in conformity with gener- sensus provides criteria for identifying “in-substance” leases of plant, ally accepted accounting principles requires management to make property, and equipment within supply agreements, service contracts, estimates and assumptions that affect the reported amounts of as- and other arrangements not historically accounted for as leases. This sets and liabilities and disclosure of contingent assets and liabili- guidance is generally applicable to arrangements entered into or ties at the date of the financial statements and the reported modified in interim periods beginning after May 28, 2003. The amounts of revenues and expenses during the reporting period. Company has applied this consensus prospectively beginning in its Actual results could differ from those estimates. fiscal third quarter of 2003. Management believes this guidance may apply to certain future agreements with contract manufacturers that Note 2 Keebler acquisition produce or pack the Company’s products, potentially resulting in cap- On March 26, 2001, the Company acquired Keebler Foods ital lease recognition within the balance sheet. However, the impact Company (“Keebler”) in a cash transaction valued at $4.56 billion. of this consensus during 2003 was insignificant. The acquisition was accounted for under the purchase method and Kellogg Company 37
    • was financed through a combination of short-term and long-term duction from the Grand Rapids, Michigan bakery to other facili- debt. The components of intangible assets included in the final allo- ties. As a result of these initiatives, over 800 employee positions cation of purchase price were (in millions): trademarks and trade- were relocated or eliminated. names-$1,310.0, direct store door (DSD) delivery system-$590.0, These exit plans also included the divesture of some of Keebler’s goodwill-$2,938.5. During 2001, these intangibles were amortized private-label operations. During April 2002, the Company sold cer- based on an estimated useful life of 40 years. As a result of the tain assets of the Bake-Line unit, including a bakery in Marietta, Company’s adoption of SFAS No. 142 on January 1, 2002 (refer to Oklahoma, to Atlantic Baking Group, Inc. for approximately $65 Note 1), these intangibles were no longer amortized after 2001, million in cash. In January 2003, the Company sold additional pri- but are subject to annual impairment reviews. Unaudited pro forma vate-label operations, including a bakery in Cleveland, Tennessee, combined results as if the Company had acquired Keebler as of the for approximately $14 million in cash. For both of these transac- beginning of 2001 are (in millions except per share data): net tions, the carrying value of net assets sold, including allocated sales-$8,049.8, earnings before cumulative effect of accounting goodwill, approximated the net sales proceeds. change-$430.6, net earnings-$429.6, net earnings per share (basic and diluted)-$1.06. These pro forma results include amortization of Note 3 Exit activities and the acquired intangibles and interest expense on debt assumed is- other charges sued to finance the purchase. The pro forma results are not neces- 2003-exit activities sarily indicative of what actually would have occurred if the acquisi- tion had been completed as of the beginning of 2001, nor are they To position the Company for sustained, reliable growth in earnings necessarily indicative of future consolidated results. and cash flow for the long term, management is undertaking a se- ries of cost-saving initiatives. Some of these initiatives are still in The final purchase price allocation included $71.3 million of liabili- the planning stages and individual actions are being announced ties related to management’s plans, as of the acquisition date, to as plans are finalized. Major actions implemented in 2003 include exit certain activities and operations of Keebler, as presented in a wholesome snack plant consolidation in Australia, manufactur- the table below. During the year ended December 27, 2003, $6.7 ing capacity rationalization in the Mercosur region of Latin million of excess reserves were reversed to goodwill. This excess America, and plant workforce reduction in Great Britain. resulted primarily from lower than projected facility closure costs Additionally, manufacturing and distribution network optimization and employee severance payments, and higher than projected pro- efforts in the Company’s U.S. snacks business have been ongoing ceeds from sale of leased vehicles and sub-lease revenue. since the Company’s acquisition of Keebler in 2001. Acquisition-date exit plans were substantially completed during 2003, with remaining reserves consisting primarily of contractual The wholesome snack plant consolidation in Australia involved obligations for severance and leases extending through 2011. the exit of a leased facility and separation of approximately 140 employees during 2003. The Company incurred approximately $6 Lease & other Employee Employee contract Facility closure million in exit costs and asset write-offs during 2003 related to severance benefits relocation termination costs Total (millions) this initiative. Total reserve at acquisition date: Original estimate $59.3 $8.6 $12.3 $10.4 $90.6 The manufacturing capacity rationalization in the Mercosur region Purchase accounting adjustments (10.3) (7.1) (.5) (1.4) (19.3) of Latin America involved the closure of an owned facility in Adjusted $49.0 $1.5 $11.8 $ 9.0 $71.3 Argentina and separation of approximately 85 plant and adminis- Amounts utilized during 2001 (23.9) (.8) (.4) (2.9) (28.0) trative employees during 2003. The Company recorded an impair- Amounts utilized during 2002 (17.9) (.1) (1.8) (4.2) (24.0) ment loss of approximately $6 million to reduce the carrying value 2003 activity: of the manufacturing facility to estimated fair value, and incurred Utilized (5.0) (.1) (2.9) (.3) (8.3) Reversed (1.9) (.5) (2.8) (1.5) (6.7) approximately $2 million of severance and closure costs during Remaining reserve 2003 to complete this initiative. Beginning in 2004, the Company at December 27, 2003 $ .3 $— $ 3.9 $ .1 $ 4.3 is importing its products for sale in Argentina from other Latin America facilities. Exit plans implemented during the two-year period following the acquisition date included consolidation of various adminis- The plant workforce reduction in Great Britain resulted from trative functions in Battle Creek, Michigan; consolidation of ice changes in plant crewing to better match the work pattern to the cream cone and pie crust operations within a single Chicago, demand cycle. Approximately 130 hourly and salaried employee Illinois facility; reconfiguration of Keebler’s DSD system in the positions have been eliminated through voluntary severance and southeastern United States to accommodate Kellogg snack early retirement programs. During 2003, the Company incurred product volume; closing of the Denver, Colorado bakery and approximately $18 million in separation benefit costs related to several leased distribution centers; and transferring some pro- this initiative. Earning Our Stripes 38
    • Taking into account all of these major initiatives, plus other various grams were $9.9 million, comprised of $6.4 million for severance plant productivity and overhead reduction projects, the Company and $3.5 million for asset removal. At the end of 2002, all restruc- recorded total charges of approximately $71 million during 2003, turing programs were complete and remaining reserves of $1.4 comprised of $40 million in asset write-offs, $8 million for pension million consisted solely of long-term contractual obligations for settlements, and $23 million in severance and other cash exit employee severance. costs. These charges were recorded principally in cost of goods As a result of the Keebler acquisition in March 2001, the Company sold and impacted the Company’s operating segments as follows assumed $14.9 million of reserves for severance and facility clo- (in millions): U.S.-$36, Europe-$21, Latin America-$8, all other-$6. sures related to Keebler’s ongoing restructuring and acquisition-re- Reserves for exit costs at December 27, 2003, were approximately lated synergy initiatives. Approximately $5 million of those re- $19 million, principally representing severance to be paid out dur- serves were utilized in 2001, with the remainder being ing the first half of 2004. attributable primarily to noncancelable lease obligations extending through 2006. 2003-impairments Prior years-impairments During 2003, the Company recorded in SGA an impairment loss of $10 million to reduce the carrying value of a contract-based intan- Cost of goods sold for 2002 includes an impairment loss of $5 gible asset. The asset is associated with a long-term licensing million related to the Company’s manufacturing facility in agreement principally in the United States and the decline in value China, representing a decline in real estate market value subse- was based on the proportionate decline in estimated future cash quent to an original impairment loss recognized for this prop- flows to be derived from the contract versus original projections. erty in 1997. The Company completed a sale of this facility in late 2003, and the carrying value of the property approximated Prior years-exit activities the net sales proceeds. Operating profit for 2001 includes net restructuring charges of $33.3 million ($20.5 million after tax or $.05 per share), com- Note 4 prised of $48.3 million in charges and $15.0 million in credits. Other income (expense), net The 2001 charges of $48.3 million are related to preparing Other income (expense), net includes non-operating items such as Kellogg for the Keebler integration and continued actions support- interest income, foreign exchange gains and losses, charitable do- ing the Company’s growth strategy. Specific initiatives included a nations, and gains on asset sales. Other income (expense), net for headcount reduction of about 30 in U.S. and global Company 2003 includes a credit of approximately $17 million related to fa- management, rationalization of product offerings and other ac- vorable legal settlements; a charge of $8 million for a contribution tions to combine the Kellogg and Keebler logistics systems, and re- to the Kellogg’s Corporate Citizenship Fund, a private trust estab- ductions in convenience foods capacity in Southeast Asia. lished for charitable giving; and a charge of $6.5 million to recog- Approximately two-thirds of the charges were comprised of asset nize the impairment of a cost-basis investment in an e-commerce write-offs with the remainder consisting of employee separation business venture. Other income (expense), net for 2002 consists benefits and other cash costs. primarily of a $24.7 million credit related to legal settlements. The 2001 credits of $15.0 million result from adjustments to vari- Note 5 Equity ous restructuring and asset disposal reserves. With numerous multi-year streamlining initiatives nearing completion in late 2001, Earnings per share management conducted an assessment of post-2001 reserve Basic net earnings per share is determined by dividing net earn- needs, which resulted in net reductions of $8.8 million for cash ings by the weighted average number of common shares out- outlays and $6.2 million for asset disposals. (Asset disposal re- standing during the period. Diluted net earnings per share is simi- serves are reported within Property, net, on the Consolidated larly determined, except that the denominator is increased to Balance Sheet.) The reduction in cash outlays relates primarily to include the number of additional common shares that would have lower-than-anticipated employee severance and asset removal ex- been outstanding if all dilutive potential common shares had been penditures, and higher-than-anticipated asset sale proceeds. issued. Dilutive potential common shares are comprised princi- Total cash outlays incurred for restructuring programs were ap- pally of employee stock options issued by the Company. Basic net proximately $8 million in 2002 and $35 million in 2001. At the earnings per share is reconciled to diluted net earnings per share end of 2001, remaining reserves related to all restructuring pro- as follows: Kellogg Company 39
    • Earnings before cumulative effect of accounting change Tax Pretax (expense) After-tax Average amount benefit amount (millions) shares 2001 Earnings outstanding Per share (millions, except per share data) Net earnings $ 473.6 2003 Other comprehensive income: Basic $ 787.1 407.9 $ 1.93 Foreign currency translation adjustments ($ 60.4) $ — (60.4) Dilutive employee stock options — 2.6 (.01) Cash flow hedges: Diluted $ 787.1 410.5 $ 1.92 Unrealized gain (loss) on 2002 cash flow hedges (86.3) 31.9 (54.4) Basic $ 720.9 408.4 $ 1.77 Reclassification to net earnings 8.8 (3.3) 5.5 Dilutive employee stock options — 3.1 (.02) Minimum pension liability adjustments (9.8) 3.0 (6.8) Diluted $ 720.9 411.5 $ 1.75 ($ 147.7) $ 31.6 (116.1) 2001 (a) Total comprehensive income $ 357.5 Basic $ 474.6 406.1 $ 1.17 Dilutive employee stock options — 1.1 (.01) Accumulated other comprehensive income (loss) at year end con- Diluted $ 474.6 407.2 $ 1.16 sisted of the following: (a) Results for 2001 have been restated to reflect the adoption of SFAS No. 145 in 2003 concerning the income statement classification of losses from debt extinguishment. The net loss of $7.4 incurred in 2001, which was originally classified 2003 2002 (millions) as an extraordinary loss, has been reclassified to Earnings before cumulative effect of accounting change. Refer to Note Foreign currency translation adjustments ($ 406.0) ($ 487.6) 1 for further information. Cash flow hedges – unrealized net loss (51.9) ( 46.3) Comprehensive Income Minimum pension liability adjustments (271.3) ( 319.5) Total accumulated other comprehensive income (loss) ($ 729.2) ($ 853.4) Comprehensive income includes all changes in equity during a pe- riod except those resulting from investments by or distributions to Note 6 Leases and other shareholders. Comprehensive income for the periods presented commitments consists of net earnings, minimum pension liability adjustments (re- fer to Note 9), unrealized gains and losses on cash flow hedges pur- The Company’s leases are generally for equipment and warehouse suant to SFAS No. 133 “Accounting for Derivative Instruments and space. Rent expense on all operating leases was $80.5 million in Hedging Activities”, and foreign currency translation adjustments 2003, $89.5 million in 2002, and $100.0 million in 2001. pursuant to SFAS No. 52 “Foreign Currency Translation” as follows: Additionally, the Company is subject to residual value guarantees and secondary liabilities on operating leases totaling approxi- Tax Pretax (expense) After-tax mately $15 million, for which liabilities of $1.8 million had been amount benefit amount (millions) recorded at December 27, 2003. 2003 At December 27, 2003, future minimum annual lease commitments Net earnings $ 787.1 Other comprehensive income: under noncancelable capital and operating leases were as follows: Foreign currency translation adjustments $ 81.6 $ — 81.6 Operating Capital Cash flow hedges: leases leases (millions) Unrealized gain (loss) on 2004 $ 76.4 $ 1.6 cash flow hedges (18.7) 6.6 (12.1) 2005 64.0 1.5 Reclassification to net earnings 10.3 (3.8) 6.5 2006 50.3 1.5 Minimum pension liability adjustments 75.7 (27.5) 48.2 2007 38.0 1.0 $ 148.9 ($ 24.7) 124.2 2008 34.4 — Total comprehensive income $ 911.3 2009 and beyond 103.9 — Total minimum payments $ 367.0 $ 5.6 Tax Amount representing interest (.7) Pretax (expense) After-tax Obligations under capital leases 4.9 amount benefit amount (millions) Obligations due within one year 1.3 2002 Long-term obligations under capital leases $ 3.6 Net earnings $ 720.9 Other comprehensive income: The Company’s Keebler subsidiary is guarantor on loans to inde- Foreign currency translation adjustments $ 1.6 $ — 1.6 pendent contractors for the purchase of DSD route franchises. At Cash flow hedges: year-end 2003, there were total loans outstanding of $15.2 mil- Unrealized gain (loss) on lion to 413 franchisees. All loans are variable rate with a term of cash flow hedges (2.9) 1.3 (1.6) 10 years. Related to this arrangement, the Company has estab- Reclassification to net earnings 6.9 (2.7) 4.2 Minimum pension liability adjustments (453.5) 147.3 (306.2) lished with a financial institution a one-year renewable loan facil- ($ 447.9) $ 145.9 (302.0) ity up to $17.0 million with a five-year term-out and servicing Total comprehensive income $ 418.9 arrangement. The Company has the right to revoke and resell the Earning Our Stripes 40
    • route franchises in the event of default or any other breach of con- sold outside the United States, in reliance on exemptions from registration under the Securities Act of 1933, as amended (the “1933 Act”). The Company then exchanged new debt securities for these initial debt instruments, with the new debt tract by franchisees. Revocations are infrequent. The Company’s securities being substantially identical in all respects to the initial debt instruments, except for being registered under the 1933 Act. These debt securities contain standard events of default and covenants. The Notes due 2006 and 2011, and the maximum potential future payments under these guarantees are Debentures due 2031 may be redeemed in whole or part by the Company at any time at prices determined under a for- limited to the outstanding loan principal balance plus unpaid in- mula (but not less than 100% of the principal amount plus unpaid interest to the redemption date). In conjunction with this issuance, the Company settled $1,900 notional amount of forward-starting interest rate swaps for terest. In accordance with FASB Interpretation No. 45 (refer to approximately $88 in cash. The swaps effectively fixed a portion of the interest rate on an equivalent amount of debt prior Note 1), we have recognized the fair value of guarantees associ- to issuance. The swaps were designated as cash flow hedges pursuant to SFAS No. 133 (refer to Note 12). As a result, the loss on settlement (net of tax benefit) of $56 was recorded in other comprehensive income, and is being amortized ated with new loans to DSD route franchisees issued beginning in to interest expense over periods of 5 to 30 years. The effective interest rates presented in the following table reflect this 2003. These amounts are insignificant. amortization expense, as well as discount on the debt. Principal Effective The Company has provided various standard indemnifications in amount Net proceeds interest rate (dollars in millions) agreements to sell business assets and lease facilities over the 5.5% U.S. Dollar Notes due 2003 $ 1,000.0 $ 997.4 5.64% past several years, related primarily to pre-existing tax, environ- 6.0% U.S. Dollar Notes due 2006 1,000.0 993.5 6.39% 6.6% U.S. Dollar Notes due 2011 1,500.0 1,491.2 7.08% mental, and employee benefit obligations. Certain of these indem- 7.45% U.S. Dollar Debentures due 2031 1,100.0 1,084.9 7.62% nifications are limited by agreement in either amount and/or term $ 4,600.0 $ 4,567.0 and others are unlimited. The Company has also provided various In September 2002, the Company redeemed $300.7 of the Notes due 2003 and a subsidiary of the Company issued “hold harmless” provisions within certain service type agreements. $400 of U.S. commercial paper. In April 2003, the Company repaid the remainder of the Notes due 2003. The Company initially replaced this debt with U.S. short-term debt and subsequently issued the long-term debt described in (e). In Because the Company is not currently aware of any actual expo- December 2003, the Company redeemed $172.9 of the Notes due 2006. sures associated with these indemnifications, management is un- (d) In November 2001, a subsidiary of the Company issued $375 of five-year 4.49% fixed rate U.S. Dollar Notes to replace other maturing debt. These Notes are guaranteed by the Company and mature $75 per year over the five-year term. able to estimate the maximum potential future payments to be These Notes, which were privately placed, contain standard warranties, events of default, and covenants. They also made. At December 27, 2003, the Company had not recorded any require the maintenance of a specified consolidated interest expense coverage ratio, and limit capital lease obligations and subsidiary debt. In conjunction with this issuance, the subsidiary of the Company entered into a $375 notional US$/ liability related to these indemnifications. Pound Sterling currency swap, which effectively converted this debt into a 5.302% fixed rate Pound Sterling obligation for the duration of the five-year term. Note 7 Debt (e) In June 2003, the Company issued $500 of five-year 2.875% fixed rate U.S. Dollar Notes, using the proceeds from these Notes to replace maturing long-term debt. These Notes were issued under an existing shelf registration statement. In conjunction with this issuance, the Company settled $250 notional amount of forward interest rate contracts for a Notes payable at year end consisted of commercial paper borrow- loss of $11.8, which is being amortized to interest expense over the term of the debt. Taking into account this amortiza- ings in the United States and, to a lesser extent, bank loans of for- tion and issuance discount, the effective interest rate on these five-year Notes is 3.35%. eign subsidiaries at competitive market rates, as follows: At December 27, 2003, the Company had $2.0 billion of short- term lines of credit, virtually all of which were unused and avail- 2003 2002 (dollars in millions) Effective Effective able for borrowing on an unsecured basis. These lines were com- Principal interest Principal interest prised principally of a 364-Day Credit Agreement, which was amount rate amount rate renewed in January 2004, and a Five-Year Credit Agreement, ex- U.S. commercial paper $ 296.0 1.2% $ 409.8 2.0% piring in January 2006. The 364-day agreement permits the Canadian commerical paper 15.3 3.0% — — Other 9.5 11.1 Company or certain subsidiaries to borrow up to $650 million. The $ 320.8 $ 420.9 five-year agreement permits the Company or certain subsidiaries to borrow up to $1.15 billion (or certain amounts in foreign cur- Long-term debt at year end consisted primarily of fixed rate is- rencies). These two credit agreements contain standard warranties, suances of U.S. and Euro Dollar Notes, as follows: events of default, and covenants. They also require the mainte- 2003 2002 (millions) nance of a specified amount of consolidated net worth and a (a) 4.875% U.S. Dollar Notes due 2005 $ 200.0 $ 200.0 specified consolidated interest expense coverage ratio, and limit (b) 6.625% Euro Dollar Notes due 2004 500.0 500.0 (c) 5.5% U.S. Dollar Notes due 2003 — 699.1 capital lease obligations and subsidiary debt. (c) 6.0% U.S. Dollar Notes due 2006 824.2 995.8 Scheduled principal repayments on long-term debt are (in mil- (c) 6.6% U.S. Dollar Notes due 2011 1,493.6 1,492.7 lions): 2004-$578.1; 2005-$278.6; 2006-$904.4; 2007-$2.0; (c) 7.45% U.S. Dollar Debentures due 2031 1,086.3 1,085.8 2008-$501.4; 2009 and beyond-$2,601.7. (d) 4.49% U.S. Dollar Notes due 2006 225.0 300.0 (e) 2.875% U.S. Dollar Notes due 2008 499.9 — Interest paid was (in millions): 2003-$372; 2002-$386; 2001- Other 14.5 22.4 $303. Interest expense capitalized as part of the construction cost 4,843.5 5,295.8 of fixed assets was (in millions): 2003-$0; 2002-$1.0; 2001-$2.9. Less current maturities (578.1) (776.4) Balance at year end $4,265.4 $ 4,519.4 Note 8 Stock compensation (a) In October 1998, the Company issued $200 of seven-year 4.875% fixed rate U.S. Dollar Notes to replace maturing long- term debt. In conjunction with this issuance, the Company settled $200 notional amount of interest rate forward swap The Company uses various equity-based compensation programs agreements, which, when combined with original issue discount, effectively fixed the interest rate on the debt at 6.07%. (b) In January 1997, the Company issued $500 of seven-year 6.625% fixed rate Euro Dollar Notes. In conjunction with this to provide long-term performance incentives for its global work- issuance, the Company settled $500 notional amount of interest rate forward swap agreements, which effectively fixed the force. Currently, these incentives are administered through several interest rate on the debt at 6.354%. These Notes were repaid in January 2004. plans, as described below. (c) In March 2001, the Company issued $4,600 of long-term debt instruments, further described in the table below, primarily to finance the acquisition of Keebler Foods Company (refer to Note 2). Initially, these instruments were privately placed, or Kellogg Company 41
    • The 2003 Long-Term Incentive Plan (“2003 Plan”), approved by made restricted stock grants to eligible employees as follows (ap- shareholders in 2003, permits benefits to be awarded to employees proximate number of shares): 2003-209,000; 2002-132,000; and officers in the form of incentive and non-qualified stock op- 2001-300,000. Additionally, performance units were awarded to tions, performance shares or performance share units, restricted a limited number of senior executive-level employees for the stock or restricted stock units, and stock appreciation rights. The achievement of cumulative three-year performance targets as fol- 2003 Plan authorizes the issuance of a total of (a) 25 million lows: awarded in 2001 for cash flow targets ending in 2003; shares plus (b) shares not issued under the 2001 Long-Term awarded in 2002 for sales growth targets ending in 2004; Incentive Plan (the “2001 Plan”), with no more than 5 million awarded in 2003 for gross margin targets ending in 2005. If the shares to be issued in satisfaction of performance units, perform- performance targets are met, the award of units represents the ance-based restricted shares and other awards (excluding stock op- right to receive shares of common stock (or a combination of tions and stock appreciation rights), and with additional annual shares and cash) equal to the dollar award valued on the vesting limitations on awards or payments to individual participants. date. No awards are earned unless a minimum threshold is at- Options granted under the 2003 Plan and 2001 Plan generally vest tained. The 2001 award was earned at 200% of target and vested over two years, subject to earlier vesting if a change of control oc- in February 2004 for a total dollar equivalent of $15.5 million. The curs. Restricted stock and performance share grants under the maximum future dollar award that could be attained under the 2003 Plan and the 2001 Plan generally vest in three years, subject 2002 and 2003 awards is approximately $19 million. to earlier vesting and payment if a change in control occurs. The 2002 Employee Stock Purchase Plan was approved by share- The Non-Employee Director Stock Plan (“Director Plan”) was ap- holders in 2002 and permits eligible employees to purchase proved by shareholders in 2000 and allows each eligible non- Company stock at a discounted price. This plan allows for a maxi- employee director to receive 1,700 shares of the Company’s mum of 2.5 million shares of Company stock to be issued at a common stock annually and annual grants of options to pur- purchase price equal to the lesser of 85% of the fair market value chase 5,000 shares of the Company’s common stock. Shares of the stock on the first or last day of the quarterly purchase pe- other than options are placed in the Kellogg Company Grantor riod. Total purchases through this plan for any employee are lim- Trust for Non-Employee Directors (the “Grantor Trust”). Under ited to a fair market value of $25,000 during any calendar year. the terms of the Grantor Trust, shares are available to a director Shares were purchased by employees under this plan as follows only upon termination of service on the Board. Under this plan, (approximate number of shares): 2003-248,000; 2002-119,000. awards were as follows: 2003-55,000 options and 18,700 Additionally, during 2002, a foreign subsidiary of the Company es- shares; 2002-50,850 options and 18,700 shares; 2001-55,000 tablished a stock purchase plan for its employees. Subject to limi- options and 17,000 shares. tations, employee contributions to this plan are matched 1:1 by the Company. Under this plan, shares were granted by the Options under all plans described above are granted with exercise Company to match an approximately equal number of shares pur- prices equal to the fair market value of the Company’s common chased by employees as follows (approximate number of shares): stock at the time of the grant and have a term of no more than 2003-94,000; 2002-82,000. ten years, if they are incentive stock options, or no more than ten years and one day, if they are non-qualified stock options. In addi- The Executive Stock Purchase Plan was established in 2002 to en- tion, these plans permit stock option grants to contain an acceler- courage and enable certain eligible employees of the Company to ated ownership feature (“AOF”). An AOF option is generally acquire Company stock, and to align more closely the interests of granted when Company stock is used to pay the exercise price of those individuals and the Company’s shareholders. This plan al- a stock option or any taxes owed. The holder of the option is gen- lows for a maximum of 500,000 shares of Company stock to be erally granted an AOF option for the number of shares so used issued. Under this plan, shares were granted by the Company to with the exercise price equal to the then fair market value of the executives in lieu of cash bonuses as follows (approximate number Company’s stock. For all AOF options, the original expiration date of shares): 2003-11,000; 2002-14,000. is not changed but the options vest immediately. Transactions under these plans are presented in the tables below. In addition to employee stock option grants presented in the ta- Refer to Note 1 for information on the Company’s method of ac- bles below, under its long-term incentive plans, the Company counting for these plans. Earning Our Stripes 42
    • Obligations and funded status 2003 2002 2001 (millions) Under option, beginning of year 38.2 37.0 23.4 The aggregate change in projected benefit obligation, change in Granted 7.5 9.2 17.1 plan assets, and funded status were: Exercised (6.0) (5.2) (1.3) 2003 2002 Cancelled (2.7) (2.8) (2.2) (millions) Change in projected benefit obligation Under option, end of year 37.0 38.2 37.0 Projected benefit obligation at beginning of year $ 2,261.4 $ 2,038.7 Exercisable, end of year 24.4 20.1 16.9 Acquisition adjustment — (13.4) Average prices per share Service cost 67.5 57.0 Under option, beginning of year $ 33 $ 31 $ 34 Interest cost 151.1 140.7 Granted 31 33 27 Plan participants’ contributions 1.7 1.2 Exercised 28 27 25 Amendments 15.4 28.3 Cancelled 35 32 34 Actuarial loss 195.8 97.8 Under option, end of year $ 33 $ 33 $ 31 Benefits paid (134.9) (137.2) Exercisable, end of year $ 34 $ 34 $ 36 Foreign currency adjustments 82.7 46.2 Shares available, end of year, Other .2 2.1 for stock-based awards that may be granted Projected benefit obligation at end of year $ 2,640.9 $ 2,261.4 under the following plans: Change in plan assets Kellogg Employee Stock Ownership Plan 1.3 .6 2.8 Fair value of plan assets at beginning of year $ 1,849.5 $ 1,845.3 2000 Non-Employee Director Stock Plan .6 .6 .9 Acquisition adjustment — (21.4) 2001 Long-Term Incentive Plan — 10.1 16.1 Actual return on plan assets 456.9 (191.3) 2002 Employee Stock Purchase Plan 2.1 2.4 — Employer contributions 82.4 309.3 Executive Stock Purchase Plan .5 .5 — Plan participants’ contributions 1.7 1.2 2003 Long-Term Incentive Plan (a) 30.5 — — Benefits paid (132.3) ( 133.7) Total 35.0 14.2 19.8 Foreign currency adjustments 61.0 39.9 (a) Refer to description of 2003 Plan within this note for restrictions on availability. Other — .2 Employee stock options outstanding and exercisable under these Fair value of plan assets at end of year $ 2,319.2 $ 1,849.5 plans as of December 27, 2003, were: Funded status ($ 321.7) ($ 411.9) Unrecognized net loss 822.3 846.7 (millions, except per share data) Unrecognized transition amount 2.4 2.3 Outstanding Exercisable Unrecognized prior service cost 54.4 51.8 Weighted Weighted average Weighted Prepaid pension $ 557.4 $ 488.9 Range of average remaining average Amounts recognized in the Consolidated exercise Number exercise contractual Number exercise Balance Sheet consist of prices of options price life (yrs.) of options price Prepaid benefit cost $ 388.1 $ 364.2 $19 – 28 10.2 $ 26 7.0 7.8 $ 27 Accrued benefit liability (256.3) (376.1) 29 – 34 8.9 31 8.7 2.6 33 Intangible asset 28.0 27.5 35 – 36 10.2 35 7.8 6.6 35 Minimum pension liability 397.6 473.3 37 – 51 7.7 41 4.2 7.4 42 Net amount recognized $ 557.4 $ 488.9 37.0 24.4 The accumulated benefit obligation for all defined benefit pension Note 9 Pension benefits plans was $2.41 billion and $2.05 billion at December 27, 2003 and December 28, 2002, respectively. The projected benefit obliga- The Company sponsors a number of U.S. and foreign pension plans tion, accumulated benefit obligation, and fair value of plan assets to provide retirement benefits for its employees. The majority of for pension plans with accumulated benefit obligations in excess these plans are funded or unfunded defined benefit plans, although of plan assets were: the Company does participate in a few multiemployer or other de- fined contribution plans for certain employee groups. Defined bene- 2003 2002 (millions) Projected benefit obligation $ 1,590.4 $ 1,779.4 fits for salaried employees are generally based on salary and years Accumulated benefit obligation 1,394.6 1,569.1 of service, while union employee benefits are generally a negoti- Fair value of plan assets 1,220.0 1,340.6 ated amount for each year of service. The Company uses its fiscal year end as the measurement date for the majority of its plans. At December 27, 2003, a cumulative after-tax charge of $271.3 million ($397.6 million pretax) has been recorded in other compre- hensive income to recognize the additional minimum pension liabil- ity in excess of unrecognized prior service cost. Refer to Note 5 for further information on the changes in minimum liability included in other comprehensive income for each of the periods presented. Kellogg Company 43
    • Expense price-earnings ratios of the major stock market indices, and long- term inflation. The model currently incorporates a long-term infla- The components of pension expense were: tion assumption of 2.5% and an active management premium of 2003 2002 2001 (millions) 1% (net of fees) validated by historical analysis. Although man- Service cost $ 67.5 $ 57.0 $ 47.4 agement reviews the Company’s expected long-term rates of re- Interest cost 151.1 140.7 124.5 turn annually, the benefit trust investment performance for one Expected return on plan assets (224.3) ( 217.5) ( 192.4) particular year does not, by itself, significantly influence this evalu- Amortization of unrecognized ation. The expected rates of return are generally not revised, pro- transition obligation .1 .3 .3 Amortization of unrecognized vided these rates continue to fall within a “more likely than not” prior service cost 7.3 6.9 6.6 corridor of between the 25th and 75th percentile of expected Recognized net (gain) loss 28.6 11.5 4.6 long-term returns, as determined by the Company’s modeling Curtailment and special termination benefits - process. The current expected rate of return of 9.3% presently net (gain) loss 8.1 — (1.5) equates to approximately the 50th percentile expectation. Any fu- Pension expense (income) - Company plans 38.4 (1.1) ( 10.5) ture variance between the expected and actual rates of return on Pension expense - defined contribution plans 3.2 2.9 3.0 plan assets is recognized in the calculated value of plan assets Total pension expense (income) $ 41.6 $ 1.8 ($ 7.5) over a five-year period and once recognized, experience gains and Certain of the Company’s subsidiaries sponsor 401(k) or similar losses are amortized using a declining-balance method over the savings plans for active employees. Expense related to these plans average remaining service period of active plan participants. was (in millions): 2003-$26; 2002-$26; 2001-$25. Company con- tributions to these savings plans approximate annual expense. Plan assets Company contributions to multiemployer and other defined contri- The Company’s year-end pension plan weighted-average asset al- bution pension plans approximate the amount of annual expense locations by asset category were: presented in the table above. 2003 2002 All gains and losses, other than those related to curtailment or Equity securities 74.6% 75.5% special termination benefits, are recognized over the average re- Debt securities 24.3% 23.7% maining service period of active plan participants. Net losses from Other 1.1% .8% special termination benefits recognized in 2003 are related prima- Total 100.0% 100.0% rily to a plant workforce reduction in Great Britain. Net gains from The Company’s investment strategy for its major defined benefit curtailment and special termination benefits recognized in 2001 plans is to maintain a diversified portfolio of asset classes with the were recorded as a component of restructuring charges. Refer to primary goal of meeting long-term cash requirements as they be- Note 3 for further information. come due. Assets are invested in a prudent manner to maintain the security of funds while maximizing returns within the Assumptions Company’s guidelines. The current weighted-average target asset The worldwide weighted average actuarial assumptions used to allocation reflected by this strategy is: equity securities-78.2%; determine benefit obligations were: debt securities-21.1%; other-.7%. Investment in Company com- 2003 2002 2001 mon stock represented 1.7% and 2.0% of consolidated plan as- Discount rate 5.9% 6.6% 7.0% sets at December 27, 2003 and December 28, 2002, respectively. Long-term rate of compensation increase 4.3% 4.7% 4.7% Plan funding strategies are influenced by tax regulations. The The worldwide weighted average actuarial assumptions used to Company currently expects to contribute approximately $83 mil- determine annual net periodic benefit cost were: lion to its defined benefit pension plans during 2004. 2003 2002 2001 Note 10 Discount rate 6.6% 7.0% 7.0% Nonpension postretirement Long-term rate of compensation increase 4.7% 4.7% 4.6% and postemployment benefits Long-term rate of return on plan assets 9.3% 10.5% 10.4% Postretirement To determine the overall expected long-term rate of return on plan assets, the Company works with third party financial consultants The Company sponsors a number of plans to provide health care to model expected returns over a 20-year investment horizon with and other welfare benefits to retired employees in the United respect to the specific investment mix of its major plans. The return States and Canada, who have met certain age and service require- assumptions used reflect a combination of rigorous historical per- ments. The majority of these plans are funded or unfunded defined formance analysis and forward-looking views of the financial mar- benefit plans, although the Company does participate in a few kets including consideration of current yields on long-term bonds, multiemployer or other defined contribution plans for certain em- Earning Our Stripes 44
    • ployee groups. The Company contributes to voluntary employee the Company recognized a $16.9 million curtailment gain related benefit association (VEBA) trusts to fund certain U.S. retiree health to a change in certain retiree health care benefits from employer- and welfare benefit obligations. The Company uses its fiscal year- provided defined benefit plans to multiemployer defined contribu- end as the measurement date for these plans. tion plans. Net gains from curtailment and special termination benefits recognized in 2001 were recorded as a component of re- Obligations and funded status structuring charges. Refer to Note 3 for further information. The aggregate change in accumulated postretirement benefit obli- Assumptions gation, change in plan assets, and funded status were: The weighted average actuarial assumptions used to determine 2003 2002 (millions) benefit obligations were: Change in accumulated benefit obligation Accumulated benefit obligation at beginning of year $ 908.6 $ 895.2 2003 2002 2001 Acquisition adjustment — (2.2) Discount rate 6.0% 6.9% 7.3% Service cost 12.5 11.9 The weighted average actuarial assumptions used to determine Interest cost 60.4 60.3 annual net periodic benefit cost were: Actuarial loss 78.4 90.2 Amendments (5.9) (97.3) 2003 2002 2001 Benefits paid (51.4) (50.4) Discount rate 6.9% 7.3% 7.5% Foreign currency adjustments 3.4 .4 Long-term rate of return on plan assets 9.3% 10.5% 10.5% Other .6 .5 The Company determines the overall expected long-term rate of Accumulated benefit obligation at end of year $1,006.6 $ 908.6 Change in plan assets return on VEBA trust assets in the same manner as that described Fair value of plan assets at beginning of year $ 280.4 $ 212.6 for pension trusts in Note 9. Actual return on plan assets 69.6 (27.5) The assumed health care cost trend rate is 8.5% for 2004, decreas- Employer contributions 101.8 137.3 Benefits paid (50.1) (42.5) ing gradually to 4.5% by the year 2008 and remaining at that level Other .5 .5 thereafter. These trend rates reflect the Company’s recent historical Fair value of plan assets at end of year $ 402.2 $ 280.4 experience and management’s expectation that future rates will Funded status ($ 604.4) ($ 628.2) continue to decline. A one-percentage point change in assumed Unrecognized net loss 295.6 265.6 health care cost trend rates would have the following effects: Unrecognized prior service cost (32.0) (28.7) Accrued postretirement benefit cost recognized as a liability ($ 340.8) ($ 391.3) One percentage One percentage point increase point decrease (millions) Expense Effect on total of service and interest cost components $ 9.5 ($ 8.2) Effect on postretirement benefit obligation $ 118.2 ($ 101.0) Components of postretirement benefit expense were: In December 2003, the Medicare Prescription Drug Improvement 2003 2002 2001 (millions) and Modernization Act of 2003 (the Act) became law. The Act in- Service cost $ 12.5 $ 11.9 $ 10.7 Interest cost 60.4 60.3 49.7 troduces a prescription drug benefit under Medicare Part D, as Expected return on plan assets (32.8) (26.8) (24.5) well as a federal subsidy to sponsors of retiree health care benefit Amortization of unrecognized prior service cost (2.5) (2.3) (1.1) plans that provide a benefit that is at least actuarially equivalent Recognized net (gains) losses 12.3 9.2 (2.3) to Medicare Part D. As permitted by FASB FSP 106-1, management Curtailment and special termination has elected to defer recognition of the effects of the Act in ac- benefits - net gain — (16.9) (.2) counting for and making disclosures for the Company’s postretire- Postretirement benefit expense $ 49.9 $ 35.4 $ 32.3 ment benefit plans until authoritative guidance is issued. Refer to All gains and losses, other than those related to curtailment or Note 1 for further information. special termination benefits, are recognized over the average re- maining service period of active plan participants. During 2002, Kellogg Company 45
    • Plan assets Note 11 Income taxes Earnings before income taxes and cumulative effect of accounting The Company’s year-end VEBA trust weighted-average asset allo- change, and the provision for U.S. federal, state, and foreign taxes cations by asset category were: on these earnings, were: 2003 2002 Equity securities 66% 44% 2003 2002 2001 (a) (millions) Debt securities 21% 19% Earnings before income taxes and cumulative effect of Other 13% 37% accounting change Total 100% 100% United States $ 799.9 $ 791.3 $452.6 The Company’s asset investment strategy for its VEBA trusts is Foreign 369.6 353.0 339.9 $1,169.5 $1,144.3 $792.5 consistent with that described for its pension trusts in Note 9. The Income taxes current target asset allocation is 80% equity securities and 20% Currently payable: debt securities. Actual asset allocations at year-end 2003 and Federal $ 141.9 $ 157.1 $116.8 2002 differ significantly from the target due to late-year cash con- State 40.5 46.2 30.0 tributions not yet invested. The Company currently expects to con- Foreign 125.2 108.9 99.6 tribute approximately $67 million to its VEBA trusts during 2004. 307.6 312.2 246.4 Deferred: Postemployment Federal 91.7 82.8 53.1 State (8.6) 8.4 1.2 Under certain conditions, the Company provides benefits to former Foreign (8.3) 20.0 17.2 or inactive employees in the United States and several foreign lo- 74.8 111.2 71.5 cations, including salary continuance, severance, and long-term Total income taxes $ 382.4 $ 423.4 $ 317.9 disability. The Company recognizes an obligation for any of these (a) Results for 2001 have been restated to reflect the adoption of SFAS No. 145 in 2003 concerning the income statement classification of losses from debt extinguishment. The net loss incurred in 2001, which was originally classified as an benefits that vest or accumulate with service. Postemployment extraordinary loss, has been reclassified as follows (in millions): Earnings before income taxes and cumulative effect of benefits that do not vest or accumulate with service (such as sev- accounting change reduced by $11.6; Income taxes currently payable reduced by $4.2. Refer to Note 1 for further infor- mation. erance based solely on annual pay rather than years of service) or The difference between the U.S. federal statutory tax rate and the costs arising from actions that offer benefits to employees in ex- Company’s effective rate was: cess of those specified in the respective plans are charged to ex- pense when incurred. The Company’s postemployment benefit 2003 2002 2001 plans are unfunded. Actuarial assumptions used are consistent U.S. statutory rate 35.0% 35.0% 35.0% Foreign rates varying from 35% -.9 -.8 -1.1 with those presented for postretirement benefits above. The aggre- State income taxes, net of federal benefit 1.8 3.1 2.5 gate change in accumulated postemployment benefit obligation Foreign earnings repatriation — 2.8 — and the net amount recognized were: Donation of appreciated assets — -1.5 — 2003 2002 (millions) Net change in valuation allowances -.1 -.2 .1 Change in accumulated benefit obligation Nondeductible goodwill amortization — — 2.9 Accumulated benefit obligation at beginning of year $ 27.1 $35.6 Statutory rate changes, deferred tax impact -.1 — -.1 Service cost 3.0 2.0 Other -3.0 -1.4 .8 Interest cost 2.0 1.7 Effective income tax rate 32.7% 37.0% 40.1% Actuarial loss 11.3 (6.9) The effective income tax rate for 2001 of approximately 40% re- Benefits paid (9.2) (5.5) flected the impact of the Keebler acquisition (refer to Note 2) on Foreign currency adjustmensts .8 .2 nondeductible goodwill and the level of U.S. tax on foreign sub- Accumulated benefit obligation at end of year $ 35.0 $ 27.1 Funded status ($ 35.0) ($ 27.1) sidiary earnings. As a result of the Company’s adoption of SFAS Unrecognized net loss 11.8 3.7 No. 142 on January 1, 2002 (refer to Note 1), goodwill amortiza- Accrued postemployment benefit cost recognized as a liability ($ 23.2) ($ 23.4) tion expense – and the resulting impact on the effective income Components of postemployment benefit expense were: tax rate – has been eliminated in periods subsequent to adop- tion. Accordingly, the 2002 effective income tax rate was re- 2003 2002 2001 (millions) duced to 37%. Due primarily to the implementation of various Service cost $ 3.0 $ 2.0 $ 1.8 tax planning initiatives and audit closures, the 2003 effective in- Interest cost 2.0 1.7 1.9 Recognized net losses 3.0 1.4 .9 come tax rate was lowered to 32.7%, which includes over 200 Postemployment benefit expense $ 8.0 $ 5.1 $ 4.6 basis points of single-event benefits such as revaluation of de- ferred state tax liabilities. Earning Our Stripes 46
    • Note 12 Financial instruments Generally, the changes in valuation allowances on deferred tax as- and credit risk concentration sets and corresponding impacts on the effective income tax rate, as presented in the table above, result from management’s assess- The fair values of the Company's financial instruments are based ment of the Company’s ability to utilize certain operating loss and on carrying value in the case of short-term items, quoted market tax credit carryforwards. Total tax benefits of carryforwards at year- prices for derivatives and investments, and, in the case of long- end 2003 and 2002 were approximately $40 million and $21 mil- term debt, incremental borrowing rates currently available on lion, respectively. Of the total carryforwards at year-end 2003, ap- loans with similar terms and maturities. The carrying amounts of proximately $6 million expire during 2004 and another $26 the Company's cash, cash equivalents, receivables, and notes million expire within five years. Based on management’s assess- payable approximate fair value. The fair value of the Company’s ment of the Company’s ability to utilize these benefits prior to ex- long-term debt at December 27, 2003, exceeded its carrying value piration, the carrying value of deferred tax assets associated with by approximately $499 million. carryforwards was reduced by valuation allowances to approxi- The Company is exposed to certain market risks which exist as a mately $10 million at December 27, 2003. part of its ongoing business operations and uses derivative finan- The deferred tax assets and liabilities included in the balance sheet cial and commodity instruments, where appropriate, to manage at year end were: these risks. In general, instruments used as hedges must be effec- tive at reducing the risk associated with the exposure being Deferred tax assets Deferred tax liabilities 2003 2002 2003 2002 (millions) hedged and must be designated as a hedge at the inception of the Current: contract. In accordance with SFAS No. 133 (refer to Note 1), the Promotion and advertising $ 19.0 $ 21.2 $ 8.0 $ 7.6 Company designates derivatives as either cash flow hedges, fair Wages and payroll taxes 39.9 30.3 — — value hedges, net investment hedges, or other contracts used to Inventory valuation 18.0 14.3 16.0 16.5 reduce volatility in the translation of foreign currency earnings to Health and postretirement benefits 41.2 53.9 — .1 U.S. Dollars. The fair values of all hedges are recorded in accounts State taxes 12.4 17.2 — — receivable or other current liabilities. Gains and losses representing Operating loss and credit carryforwards 1.0 .2 — — Deferred intercompany revenue — 42.6 5.0 7.5 either hedge ineffectiveness, hedge components excluded from the Keebler exit liabilities 3.0 6.7 — — assessment of effectiveness, or hedges of translational exposure Unrealized hedging losses, net 31.2 29.0 .1 .1 are recorded in other income (expense), net. Other 31.5 31.1 6.0 5.7 197.2 246.5 35.1 37.5 Cash flow hedges Less valuation allowance (3.2) (2.6) — — 194.0 243.9 35.1 37.5 Qualifying derivatives are accounted for as cash flow hedges when Noncurrent: the hedged item is a forecasted transaction. Gains and losses on Depreciation and asset disposals 10.2 9.2 365.4 348.3 these instruments are recorded in other comprehensive income Health and postretirement benefits 238.9 282.3 223.1 187.2 until the underlying transaction is recorded in earnings. When the Capitalized interest — — 12.6 17.2 hedged item is realized, gains or losses are reclassified from accu- State taxes — — 74.8 88.3 mulated other comprehensive income to the Statement of Operating loss and credit carryforwards 39.1 20.9 — — Earnings on the same line item as the underlying transaction. For Trademarks and other intangibles — — 665.7 665.2 Deferred compensation 39.8 41.9 — — all cash flow hedges, gains and losses representing either hedge Other 11.3 21.8 6.5 10.5 ineffectiveness or hedge components excluded from the assess- 339.3 376.1 1,348.1 1,316.7 ment of effectiveness were insignificant during the periods pre- Less valuation allowance (33.6) (32.1) — — sented. 305.7 344.0 1,348.1 1,316.7 Total deferred taxes $ 499.7 $ 587.9 $ 1,383.2 $ 1,354.2 The total net loss attributable to cash flow hedges recorded in ac- cumulated other comprehensive income at December 27, 2003, At December 27, 2003, foreign subsidiary earnings of approxi- was $51.9 million, related primarily to forward-starting interest mately $1.09 billion were considered permanently invested in rate swaps settled during 2001 (refer to Note 7). This loss is being those businesses. Accordingly, U.S. income taxes have not been reclassified into interest expense over periods of 5 to 30 years. provided on these earnings. Other insignificant amounts related to foreign currency and com- Cash paid for income taxes was (in millions): 2003-$289; 2002- modity price cash flow hedges will be reclassified into earnings $250; 2001-$196. The 2001 amount is net of a tax refund of ap- during the next 18 months. proximately $73 million related to the cash-out of Keebler em- ployee and director stock options upon acquisition of Keebler Fair value hedges Foods Company. Qualifying derivatives are accounted for as fair value hedges when the hedged item is a recognized asset, liability, or firm commit- Kellogg Company 47
    • ment. Gains and losses on these instruments are recorded in earn- as fair value hedges and the assessment of effectiveness is based ings, offsetting gains and losses on the hedged item. For all fair on changes in the fair value of the underlying debt, using incre- value hedges, gains and losses representing either hedge ineffec- mental borrowing rates currently available on loans with similar tiveness or hedge components excluded from the assessment of terms and maturities. effectiveness were insignificant during the periods presented. Price risk Net investment hedges The Company is exposed to price fluctuations primarily as a result Qualifying derivative and nonderivative financial instruments are of anticipated purchases of raw and packaging materials. The accounted for as net investment hedges when the hedged item is Company uses the combination of long cash positions with suppli- a foreign currency investment in a subsidiary. Gains and losses on ers, and exchange-traded futures and option contracts to reduce these instruments are recorded as a foreign currency translation price fluctuations in a desired percentage of forecasted purchases adjustment in other comprehensive income. over a duration of generally less than 18 months. Commodity contracts are accounted for as cash flow hedges. The Other contracts assessment of effectiveness is based on changes in futures prices. The Company also enters into foreign currency forward contracts Credit risk concentration and options to reduce volatility in the translation of foreign cur- rency earnings to U.S. Dollars. Gains and losses on these instru- The Company is exposed to credit loss in the event of nonperfor- ments are recorded in other income (expense), net, generally reduc- mance by counterparties on derivative financial and commodity ing the exposure to translation volatility during a full-year period. contracts. This credit loss is limited to the cost of replacing these contracts at current market rates. Management believes the proba- Foreign exchange risk bility of such loss is remote. The Company is exposed to fluctuations in foreign currency cash Financial instruments, which potentially subject the Company to flows related primarily to third-party purchases, intercompany concentrations of credit risk, are primarily cash, cash equivalents, loans and product shipments, and nonfunctional currency denomi- and accounts receivable. The Company places its investments in nated third party debt. The Company is also exposed to fluctua- highly rated financial institutions and investment-grade short-term tions in the value of foreign currency investments in subsidiaries debt instruments, and limits the amount of credit exposure to any and cash flows related to repatriation of these investments. one entity. Historically, concentrations of credit risk with respect to Additionally, the Company is exposed to volatility in the transla- accounts receivable have been limited due to the large number of tion of foreign currency earnings to U.S. Dollars. The Company as- customers, generally short payment terms, and their dispersion sesses foreign currency risk based on transactional cash flows and across geographic areas. However, there has been significant translational positions and enters into forward contracts, options, worldwide consolidation in the grocery industry in recent years. At and currency swaps to reduce fluctuations in net long or short cur- December 27, 2003, the Company’s five largest customers globally rency positions. Forward contracts and options are generally less comprised approximately 20% of consolidated accounts receivable. than 18 months duration. Currency swap agreements are estab- lished in conjunction with the term of underlying debt issues. Note 13 Quarterly financial data (unaudited) For foreign currency cash flow and fair value hedges, the assess- ment of effectiveness is generally based on changes in spot rates. (millions, except Net sales Gross profit per share data) Changes in time value are reported in other income (expense), net. 2003 2002 2003 2002 Interest rate risk First $ 2,147.5 $2,061.8 $ 916.4 $ 884.6 Second 2,247.4 2,125.1 1,015.3 963.6 The Company is exposed to interest rate volatility with regard to Third 2,281.6 2,136.5 1,034.0 973.1 future issuances of fixed rate debt and existing issuances of vari- Fourth 2,135.0 1,980.7 946.9 913.8 able rate debt. The Company currently uses interest rate swaps, in- $ 8,811.5 $8,304.1 $ 3,912.6 $3,735.1 Net earnings Net earnings per share cluding forward-starting swaps, to reduce interest rate volatility 2003 2002 2003 2002 and funding costs associated with certain debt issues, and to Basic Diluted Basic Diluted achieve a desired proportion of variable versus fixed rate debt, First $ 163.9 $152.6 $ .40 $.40 $ .37 $ .37 based on current and projected market conditions. Second 203.9 173.8 .50 .50 .42 .42 Third 231.3 203.5 .57 .56 .50 .49 Variable-to-fixed interest rate swaps are accounted for as cash Fourth 188.0 191.0 .46 .46 .47 .47 flow hedges and the assessment of effectiveness is based on $ 787.1 $720.9 changes in the present value of interest payments on the underly- ing debt. Fixed-to-variable interest rate swaps are accounted for Earning Our Stripes 48
    • The principal market for trading Kellogg shares is the New York 2003 2002 2001 (millions) Stock Exchange (NYSE). The shares are also traded on the Boston, Net sales Chicago, Cincinnati, Pacific, and Philadelphia Stock Exchanges. At United States $ 5,629.3 $ 5,525.4 $ 4,889.4 Europe 1,734.2 1,469.8 1,360.7 year-end 2003, the closing price (on the NYSE) was $37.80 and Latin America 645.7 631.1 650.0 there were 44,635 shareholders of record. All other operating segments 802.3 677.8 648.3 Dividends paid per share and the quarterly price ranges on the Consolidated $ 8,811.5 $ 8,304.1 $ 7,548.4 NYSE during the last two years were: Segment operating profit United States $ 1,055.0 $ 1,073.0 $ 875.5 Stock price Dividend Europe 279.8 252.5 245.6 2003 – Quarter per share High Low Latin America 168.5 170.1 171.1 First $ .2525 $ 34.96 $ 28.02 All other operating segments 140.0 104.0 103.1 Second .2525 35.36 30.46 Corporate (99.2) ( 91.5) ( 90.5) Third .2525 35.04 33.06 Consolidated $ 1,544.1 $ 1,508.1 $ 1,304.8 Fourth .2525 37.80 32.92 Amortization eliminated by SFAS No. 142 (b) — — (103.6) $ 1.0100 Restructuring charges (a) — — (33.3) 2002 – Quarter Operating profit as reported $ 1,544.1 $ 1,508.1 $ 1,167.9 First $ .2525 $ 34.95 $ 29.35 Restructuring charges (a) Second .2525 36.89 32.75 United States $ — $ — $ 29.5 Third .2525 35.63 30.00 Europe — — (.2) Fourth .2525 36.06 31.81 Latin America — — (.1) $ 1.0100 All other operating segments — — 1.4 Corporate — — 2.7 Note 14 Operating segments Consolidated $ — $ — $ 33.3 Depreciation and amortization Kellogg Company is the world’s leading producer of cereal and a United States $ 238.2 $ 221.2 $ 275.9 leading producer of convenience foods, including cookies, crackers, Europe 71.1 65.7 59.5 toaster pastries, cereal bars, frozen waffles, and meat alternatives. Latin America 21.6 17.1 21.7 Kellogg products are manufactured and marketed globally. All other operating segments 28.2 30.0 31.4 Principal markets for these products include the United States and Corporate 13.7 15.9 50.1 United Kingdom. Consolidated $ 372.8 $ 349.9 $ 438.6 Interest expense In recent years, the Company has been managed in two major divi- United States $ 1.0 $ 3.3 $ 5.7 sions - the United States and International - with International fur- Europe 18.2 22.3 2.9 ther delineated into Europe, Latin America, Canada, Australia, and Latin America .2 .6 2.8 Asia. Thus, the Company’s reportable operating segments under All other operating segments 3.3 3.4 1.5 Corporate 348.7 361.6 338.6 SFAS No. 131 “Disclosures about Segments of an Enterprise and Consolidated $ 371.4 $ 391.2 $ 351.5 Related Information” consist of the United States, Europe, and Income taxes excluding charges (a) Latin America. All other geographic areas have been combined un- United States $ 325.0 $ 349.8 $ 235.5 der the quantitative threshold guidelines of SFAS No. 131 for pur- Europe 54.6 46.3 54.4 poses of the information presented below. While this historical or- Latin America 40.0 42.5 40.3 ganizational structure is the basis of the operating segment data All other operating segments 23.3 22.2 18.1 Corporate (60.5) (37.4) (17.6) presented in this report, we recently reorganized our geographic Consolidated $ 382.4 $ 423.4 $ 330.7 management structure to North America, Europe, Latin America, Effect of charges — — (12.8) and Asia Pacific, and we will begin reporting on this basis for 2004. Income taxes as reported $ 382.4 $ 423.4 $ 317.9 The measurement of operating segment results is generally consis- Total assets United States $ 10,061.4 $ 9,784.7 $ 9,634.4 tent with the presentation of the Consolidated Statement of Earnings Europe 1,801.7 1,687.3 1,801.0 and Balance Sheet. Intercompany transactions between reportable Latin America 341.2 337.4 415.5 operating segments were insignificant in all periods presented. All other operating segments 620.8 554.0 681.2 Corporate 6,362.3 6,112.1 5,697.6 Elimination entries (8,956.6) (8,256.2) (7,861.1) Consolidated $ 10,230.8 $ 10,219.3 $ 10,368.6 (a) Refer to Note 3 for further information on restructuring charges. (b) Pro forma impact of amorization eliminated by SFAS No. 142. Refer to Note 1 for further information. Kellogg Company 49
    • (millions) 2003 2002 2001 (millions) Consolidated Balance Sheet 2003 2002 Additions to long-lived assets Trade receivables $ 716.8 $ 681.0 United States $ 180.4 $ 197.4 $ 5,601.2 Allowance for doubtful accounts (15.1) (16.0) Europe 35.5 33.4 43.8 Other receivables 53.1 76.0 Latin America 15.4 13.6 11.7 Accounts receivable, net $ 754.8 $ 741.0 All other operating segments 15.3 10.1 10.8 Raw materials and supplies $ 185.3 $ 172.2 Corporate .6 1.2 29.5 Finished goods and materials in process 464.5 431.0 Consolidated $ 247.2 $ 255.7 $ 5,697.0 Inventories $ 649.8 $ 603.2 The Company’s largest customer, Wal-Mart Stores, Inc. and its affil- Deferred income taxes $ 150.0 $ 207.8 Other prepaid assets 101.4 110.8 iates, accounted for approximately 13% of consolidated net sales Other current assets $ 251.4 $ 318.6 during 2003, 12% in 2002, and 11% in 2001, comprised princi- Land $ 75.1 $ 62.6 pally of sales within the United States. Buildings 1,417.5 1,345.6 Supplemental geographic information is provided below for net Machinery and equipment 4,555.3 4,284.8 Construction in progress 171.6 159.6 sales to external customers and long-lived assets: Accumulated depreciation (3,439.3) (3,012.4) 2003 2002 2001 (millions) Property, net $ 2,780.2 $ 2,840.2 Net sales Goodwill $ 3,098.4 $ 3,106.6 United States $ 5,629.3 $ 5,525.4 $ 4,889.4 Other intangibles 2,069.5 2,069.1 United Kingdom 740.2 667.4 622.8 -Accumulated amortization (35.1) (22.1) Other foreign countries 2,442.0 2,111.3 2,036.2 Other 520.6 462.1 Consolidated $ 8,811.5 $ 8,304.1 $ 7,548.4 Other assets $ 5,653.4 $ 5,615.7 Long-lived assets Accrued income taxes $ 143.0 $ 151.7 United States $ 7,350.5 $ 7,434.2 $ 7,275.9 Accrued salaries and wages 261.1 228.0 United Kingdom 435.1 423.5 526.6 Accrued advertising and promotion 323.1 309.0 Other foreign countries 627.6 584.6 651.5 Accrued interest 108.3 123.2 Consolidated $ 8,413.2 $ 8,442.3 $ 8,454.0 Other 327.8 386.7 Other current liabilities $ 1,163.3 $ 1,198.6 Supplemental product information is provided below for net sales Nonpension postretirement benefits $ 291.0 $ 329.6 to external customers: Deferred income taxes 1,062.8 986.4 2003 2002 2001 (millions) Other 402.4 473.9 United States Other liabilities $ 1,756.2 $ 1,789.9 Retail channel cereal $ 2,086.6 $ 1,951.6 $ 1,840.4 (millions) Retail channel snacks 2,134.9 2,206.4 1,922.7 Intangible assets subject to amortization Other 1,407.8 1,367.4 1,126.3 Gross carrying amount Accumulated amortization International 2003 2002 2003 2002 Cereal 2,801.6 2,476.9 2,381.5 Trademarks $29.5 $ 29.5 $ 18.3 $ 17.2 Convenience foods 380.6 301.8 277.5 Other 29.1 29.2 16.8 4.9 Consolidated $ 8,811.5 $ 8,304.1 $ 7,548.4 Total $58.6 $ 58.7 $35.1 $ 22.1 Note 15 Supplemental 2003 (b) 2002 financial statement data Amortization expense (a) $ 13.0 $ 3.0 (millions) (a) The currently estimated aggregate amortization expense for each of the 5 succeeding fiscal years is approximately $3 Consolidated Statement of Earnings 2003 2002 2001 per year. Research and development expense $ 126.7 $ 106.4 $ 110.2 (b) Amortization for 2003 includes an impairment loss of $10. Refer to Note 3 for further information. Advertising expense $ 698.9 $ 588.7 $ 519.2 (millions) Intangible assets not subject to amortization Total carrying amount Consolidated Statement of Cash Flows 2003 2002 2001 2003 2002 Accounts receivable ($ 17.9) $ 28.1 $ 100.9 Trademarks $ 1,404.0 $ 1,404.0 Inventories (48.2) (26.4) 15.8 Direct store door (DSD) delivery system 578.9 578.9 Other current assets .4 70.7 (5.0) Other 28.0 27.5 Accounts payable 84.8 41.3 47.6 Total $ 2,010.9 $ 2,010.4 Other current liabilities 25.3 83.8 111.6 Changes in operating assets and liabilities $ 44.4 $ 197.5 $ 270.9 Earning Our Stripes 50
    • As discussed in Note 1, the Company adopted SFAS No. 142 Changes in the carrying amount of goodwill “Goodwill and Other Intangible Assets” on January 1, 2002. The Latin Consoli- United States Europe America Other (b) dated (millions) provisions of SFAS No. 142 are adopted prospectively and prior- January 1, 2002 $3,065.0 — $ 3.1 $ 1.4 $ 3,069.5 period financial statements are not restated. Comparative earn- SFAS No. 142 reclassification (a) 46.3 — — — 46.3 ings information for 2001 is presented in the following table: Purchase accounting adjustments 22.2 — — — 22.2 2003 2002 2001 (a) (millions, except per share data) Dispositions (30.3) — — — (30.3) Net earnings Foreign currency remeasurement Originally reported $ 787.1 $ 720.9 $ 473.6 impact and other — — (1.1) — (1.1) Goodwill amortization — — 59.0 December 28, 2002 $ 3,103.2 — $ 2.0 $ 1.4 $ 3,106.6 Intangibles no longer amortized — — 26.0 Purchase accounting adjustments (4.2) — — — (4.2) Total amortization $— $— $ 85.0 Dispositions (5.0) — — — (5.0) Comparable $ 787.1 $ 720.9 $ 558.6 Foreign currency remeasurement Net earnings per share – basic impact and other (.2) — .5 .7 1.0 Originally reported $ 1.93 $ 1.77 $ 1.17 December 27, 2003 $3,093.8 — $ 2.5 $ 2.1 $3,098.4 Goodwill amortization — — .15 (a) Assembled workforce intangible no longer meets separability criteria under SFAS No. 142 and has been reclassified to Intangibles no longer amortized — — .06 goodwill effective January 1, 2002. Total amortization $— $— $ .21 (b) Other operating segments include Australia, Asia, and Canada. Comparable $ 1.93 $ 1.77 $ 1.38 Net earnings per share – diluted Originally reported $ 1.92 $ 1.75 $ 1.16 Goodwill amortization — — .15 Intangibles no longer amortized — — .06 Total amortization $— $— $ .21 Comparable $ 1.92 $ 1.75 $ 1.37 (a) Results for 2001 have been restated to reflect the adoption of SFAS No. 145 in 2003 concerning the income statement classification of losses from debt extinguishment. The net loss of $7.4 incurred in 2001, which was originally classified as an extraordinary loss, has been reclassified to Earnings before cumulative effect of accounting change. After this reclassification, Earnings before cumulative effect of accounting change was not materially different from Net earnings. Refer to Note 1 for further information. Kellogg Company 51
    • Management’s Report of Responsibility for Independent Auditors Financial Statements PricewaterhouseCoopers LLP To the Shareholders and Board of Directors The management of Kellogg Company is responsible for the relia- of Kellogg Company bility of the consolidated financial statements and related notes. In our opinion, the accompanying consolidated balance sheets and The financial statements were prepared in conformity with ac- the related consolidated statements of earnings, of shareholders’ counting principles that are generally accepted in the United equity and of cash flows present fairly, in all material respects, the States, using our best estimates and judgements as required. financial position of Kellogg Company and its subsidiaries at We maintain a system of internal controls designed to provide rea- December 27, 2003 and December 28, 2002, and the results of sonable assurance of the reliability of the financial statements, as their operations and their cash flows for each of the three years in well as to safeguard assets from unauthorized use or disposition. the period ended December 27, 2003 in conformity with account- Formal policies and procedures, including an active Ethics and ing principles generally accepted in the United States of America. Business Conduct program, support the internal controls, and are These financial statements are the responsibility of the Company’s designed to ensure employees adhere to the highest standards of management; our responsibility is to express an opinion on these personal and professional integrity. We have established a vigor- financial statements based on our audits. We conducted our au- ous internal audit program that independently evaluates the ade- dits of these statements in accordance with auditing standards quacy and effectiveness of these internal controls. generally accepted in the United States of America, which require The Audit Committee of the Board of Directors meets regularly that we plan and perform the audit to obtain reasonable assur- with management, internal auditors, and independent auditors to ance about whether the financial statements are free of material review internal control, auditing, and financial reporting matters. misstatement. An audit includes examining, on a test basis, evi- Both our independent auditors and internal auditors have free ac- dence supporting the amounts and disclosures in the financial cess to the Audit Committee. statements, assessing the accounting principles used and signifi- cant estimates made by management, and evaluating the overall We believe these consolidated financial statements do not mis- financial statement presentation. We believe that our audits pro- state or omit any material facts. Our formal certification to the vide a reasonable basis for our opinion. Securities and Exchange Commission is made with our Annual Report on Form 10-K. As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for goodwill and The independent auditing firm of PricewaterhouseCoopers LLP other intangible assets in conformity with Statement of Financial was retained to audit our consolidated financial statements and Accounting Standards No. 142, “Goodwill and Other Intangible their report follows. Assets” which was adopted as of January 1, 2002. C. M. Gutierrez Battle Creek, Michigan Chairman of the Board Chief Executive Officer January 28, 2004 J. A. Bryant Executive Vice President Chief Financial Officer J. M. Boromisa Senior Vice President Chief Accounting Officer Earning Our Stripes 52
    • Kellogg USA Kellogg International Products Products Kellogg’s® cereals, breading products, cereal bars Kellogg’s® cereals, croutons, breading and stuffing products All-Bran®, Choco Big®, Choco Krispis®, Chocos®, Coco Kellogg’s Corn Flakes®, Kellogg’s Frosted Flakes®, All-Bran®, Pops®, Choco Pops®, Corn Frosties®, Crispix®, Crunchy Nut Apple Jacks®, Corn Pops®, Crispix®, Froot Loops®, Corn Flakes®, Day Dawn®, Kellogg’s Extra®, Froot Loops®, Honey Crunch Corn Flakes®, Mini-Wheats®, Raisin Bran Froot Ring™, Frosties®, Fruit ’n Fibre®, Just Right®, Nutri- Crunch®, Rice Krispies®, Smart Start®, Special K®, Variety® Grain®, Optima®, Smacks®, Special K®, Sucrilhos®, Pak cereals Zucaritas® cereals Keebler® cookies, crackers, pie crusts, ice cream cones Nutri-Grain®, Rice Krispies Squares®, Rice Krispies Treats®, Pop-Tarts® toaster pastries Special K®, Kuadri Krispis®, Day Dawn®, Coco Pops®, Nutri-Grain®, Rice Krispies Treats®, Nutri-Grain Twists™, Crusli®, Sunibrite®, Nutri-Grain Twists®, K-time®, Special K® cereal bars Elevenses®, Milkrunch®, Be Natural®, LCMs® cereal bars Eggo® waffles, pancakes Pop-Tarts® toaster pastries Cheez-It® crackers, snacks Eggo® waffles Murray®, Famous Amos® cookies Kaos® snacks Austin® snacks Keloketas® cookies Morningstar Farms®, Natural Touch®, Loma Linda®, Komplete® biscuits Worthington® meat and dairy alternatives Vector® meal replacement products, Kashi® cereals, nutrition bars and mixes energy bar nutritional supplements Kellogg’s Krave® refueling bars Winders® fruit snacks Manufacturing Locations Manufacturing Locations San Jose, California Grand Rapids, Michigan Charmhaven, Australia Taloja, India Athens, Georgia Omaha, Nebraska Sydney, Australia Takasaki, Japan Atlanta, Georgia Blue Anchor, New Jersey Sao Paulo, Brazil Linares, Mexico Augusta, Georgia Cary, North Carolina London, Ontario, Canada Queretaro, Mexico Columbus, Georgia Charlotte, North Carolina Bogota, Colombia Springs, South Africa Macon, Georgia Cincinnati, Ohio Guayaquil, Ecuador Anseong, South Korea Rome, Georgia Fremont, Ohio Bremen, Germany Valls, Spain Chicago, Illinois Worthington, Ohio Manchester, Great Britain Rayong, Thailand Des Plaines, Illinois Zanesville, Ohio Wrexham, Great Britain Maracay, Venezuela Kansas City, Kansas Lancaster, Pennsylvania Guatemala City, Guatemala Florence, Kentucky Muncy, Pennsylvania Louisville, Kentucky Memphis, Tennessee Pikeville, Kentucky Rossville, Tennessee Battle Creek, Michigan Kellogg Company 53
    • Board of Directors William C. Richardson (E,C,F*,M,S) President and L. Daniel Jorndt Chief Executive Officer (A,M) Carlos M. Gutierrez W. K. Kellogg Foundation Chairman, Retired (E*) Battle Creek, Michigan Walgreen Co. William D. Perez Chairman of the Board Age 63 Deerfield, Illinois (A,M) Chief Executive Officer Elected 1996 Age 62 President and Kellogg Company Elected 2002 Chief Executive Officer John L. Zabriskie Age 50 S. C. Johnson & Son, Inc. (E,A,C*,F,N) Elected 1999 Racine, Wisconsin Co-Founder Age 56 PureTech Ventures, L.L.C. Elected 2000 Boston, Massachusetts Age 64 Elected 1995 Great companies start with effective governance. A competitive advantage for Kellogg is our knowledgeable and independent Board of Directors. Our Directors contribute unique professional experiences and leadership perspectives that help us respond to the complex and varied issues of a global, publicly-traded company. Each has a keen understanding of our business and therefore can effectively challenge management on any issues or plans. They also take corporate governance very seriously. Many of our governance practices were in effect prior to changes required by regulatory bodies and stock exchanges. We value the wisdom and insights of our Board, and you should feel confident that it too is earning its stripes every day. Earning Our Stripes 54
    • Gordon Gund Ann McLaughlin Korologos John T. Dillon (left) Dorothy A. Johnson (E,C,F,M,N*) (C,M,N,A) (A*,F) (F,M,S) Chairman and Senior Advisor Chairman and Chief President Chief Executive Officer Benedetto, Gartland & Company, Executive Officer, Retired Ahlburg Company Gund Investment Inc. International Paper Company Grand Haven, Michigan Corporation New York, New York Stamford, Connecticut Age 63 Princeton, New Jersey Chairman Emeritus Age 65 Elected 1998 Age 64 The Aspen Institute Elected 2000 Elected 1986 Aspen, Colorado Claudio X. Gonzalez Age 62 Benjamin S. Carson, Sr., M.D. James M. Jenness (E,C,F,M,N) Elected 1989 (E,N,S*) (M*,E,S,F) Chairman of the Board Professor and Director of Chief Executive Officer Chief Executive Officer Pediatric Neurosurgery Integrated Merchandising Kimberly-Clark de The John Hopkins Medical Systems, L.L.C. Mexico Institutions Chicago, Illinois Mexico City, Mexico Baltimore, Maryland Age 57 Age 69 Age 52 Elected 2000 Elected 1990 Elected 1997 E= Executive Committee C= Compensation Committee M= Consumer Marketing Committee A= Audit Committee F= Finance Committee N= Nominating and Corporate Governance Committee S= Social Responsibility Committee *Committee Chairman Kellogg Company 55
    • CORPORATE OFFICERS Carlos M. Gutierrez* Celeste A. Clark* Michael J. Libbing Chairman of the Board Senior Vice President Vice President Chief Executive Officer Corporate Affairs Corporate Development Age 50 Age 50 Age 34 A. D. David Mackay* Bradford J. Davidson Paul T. Norman President Senior Vice President Vice President Chief Operating Officer President, U.S. Snacks Managing Director, United Kingdom/ Age 48 Age 43 Republic of Ireland Age 39 John A. Bryant* Gustavo F. Martinez Executive Vice President Senior Vice President David J. Pfanzelter Chief Financial Officer Executive Vice President, Vice President Age 38 Kellogg International President, President, Kellogg Latin America U.S. Food Away From Home Alan F. Harris* Age 49 Age 50 Executive Vice President Chief Marketing & Customer Officer Timothy P. Mobsby Kevin C. Smith Age 49 Senior Vice President Vice President Executive Vice President, Senior Vice President, Jeffrey W. Montie Kellogg International U.S. Marketing Services Executive Vice President President, Kellogg Europe Age 53 President, Age 48 Morning Foods, Kellogg North Joseph J. Tubilewicz America Gary H. Pilnick* Vice President Age 42 Senior Vice President Global Procurement General Counsel & Secretary Age 56 Lawrence J. Pilon* Age 39 Executive Vice President Juan Pablo Villalobos Human Resources H. Ray Shei Vice President Age 55 Senior Vice President Managing Director, Chief Information Officer Kellogg de Mexico King T. Pouw* Age 53 Age 38 Executive Vice President Operations and Technology Elisabeth Fleuriot Joel R. Wittenberg Age 52 Vice President Vice President Managing Director, France/Benelux/ Treasurer Donna J. Banks Scandinavia/South Africa Age 43 Senior Vice President Age 47 Research, Quality & Technology *Member of Age 47 George A. Franklin Executive Management Vice President Committee Jeffrey M. Boromisa Worldwide Government Relations Senior Vice President Age 52 Corporate Controller Age 48 Earning Our Stripes 56
    • SHARE OWNER INFORMATION Kellogg Company COMPANY INFORMATION: Kellogg Company’s website – www.kelloggcompany.com – con- One Kellogg Square tains a wide range of information about the Company, including Battle Creek, MI 49016-3599 news releases, the Annual Report, investor information, corpo- (269) 961-2000 rate governance, nutritional information, and recipes. Common Stock: Copies of the Annual Report on audio cassette for visually Listed on the New York Stock Exchange, Ticker Symbol: K impaired share owners, the Annual Report on Form 10-K, quar- terly reports on Form 10-Q, and other Company information are INDEPENDENT ACCOUNTANTS: available upon request from: PricewaterhouseCoopers LLP Kellogg Company TRANSFER AGENT, REGISTRAR, P.O. Box CAMB AND DIVIDEND DISBURSING AGENT: Battle Creek, MI 49016-1986 Communications concerning stock transfer, dividend payments, (800) 962-1413 lost certificates, and change of address should be directed to: SHARE OWNER SERVICES: (269) 961-2380 Wells Fargo Shareowner Services 161 North Concord Exchange KELLOGG BETTER GOVERNMENT COMMITTEE: South St. Paul, MN 55075 This committee is organized to permit Company share owners, (877) 910-5385 executives, administrative personnel, and their families to pool their contributions in support of candidates for elected offices at TRUSTEE: the federal level who believe in sound economic policy and real BNY Midwest Trust Company growth, and who will fight inflation and unemployment, try to 2 North LaSalle Street, Suite 1020 decrease taxes, and reduce the growth of government. Interested Chicago, IL 60602 share owners are invited to write for further information: Kellogg Better Government Committee 4.875% Notes ATTN: Neil G. Nyberg Due October 15, 2005 One Kellogg Square 6.00% Notes Battle Creek, MI 49016-3599 Due April 1, 2006 2.875% Notes TRADEMARKS: Due June 1, 2008 Throughout this Annual Report, references in italics represent 6.60% Notes worldwide trademarks or product names owned by or associated Due April 1, 2011 with Kellogg Company or the other owners listed below. 7.45% Debentures Page 10, 12, 13, 14, 18 Due April 1, 2031 © 2004 Disney as to Disney elements. CARTOON NETWORK and the logo trademarks of Cartoon Network DIVIDEND REINVESTMENT AND STOCK PURCHASE PLAN: ©2004. This plan, available to share owners, allows for full or partial divi- SCOOBY-DOO and all related characters and elements are trademarks dend reinvestment and voluntary cash purchases, with brokerage of © Hanna-Barbera. (S04) commissions and service charges paid by the Company. For SPIDER-MAN: Spider-Man and all related characters: ™ & © 2004 Marvel details, contact: Characters, Inc. AMERICAN IDOL: American Idol © 2004 19TV Ltd., and FremantleMedia Wells Fargo Shareowner Services Operations BV. ™ 161 North Concord Exchange X-MEN 2 ™ & © 2002 Twentieth Century Fox Film Corporation. South St. Paul, MN 55075 All Rights Reserved. (877) 910-5385 The movie “Dr. Seuss’ The Cat in the Hat” © 2003 Universal Studios and DreamWorks LLC. Based on The Cat in the Hat book and characters ™ & INVESTOR RELATIONS: © 1957 Dr. Seuss Enterprises, L.P. Licensed by Universal Studios Licensing John P. Renwick, CFA LLP All Rights Reserved. Vice President, Investor Relations and Corporate Planning THE SIMPSONS ™ & © 2003 Twentieth Century Fox Film Corporation. (269) 961-6365 All Rights Reserved. SUBWAY: Doctor’s Associates, Inc. All Rights Reserved. ® Simon D. Burton, CFA MCDONALDS: ® 2004 McDonald’s Corporation. All Rights Reserved. ® Director, Investor Relations and Competitor Analysis (C) 2003 Viacom International Inc. All Rights Reserved. (269) 961-6636 Nickelodeon, SpongeBob SquarePants and all related titles, logos and characters are trademarks of Viacom International Inc. Created by Stephen Hillenburg. TM, ®, © 2004 Kellogg NA Co. CADBURY is a registered trademark of Cadbury Trebor Allan Inc.
    • EARNING OUR STRIPES. Kellogg Company One Kellogg Square Battle Creek, Michigan 49016-3599 Telephone (269) 961-2000 www.kelloggcompany.com